How to Enhance Directors' Independence at Controlled Companies

By Strampelli, Giovanni | Journal of Corporation Law, Fall 2018 | Go to article overview

How to Enhance Directors' Independence at Controlled Companies


Strampelli, Giovanni, Journal of Corporation Law


I. Introduction

Director independence has become a common feature of issuer governance all around the world. In many legal systems, corporate governance rules and principles require a large part-often, the majority-of the board to be independent.1 The role of independent directors was first enhanced with the rise of the monitoring board model-introduced by Eisenberg's seminal 1976 book "The Structure of the Corporation"2-according to which the main function of the board is to monitor the management of the company. Subsequently, the role of independent directors was further expanded following the financial scandals during the early 2000s, which prompted regulatory responses on both sides of the Atlantic that were heavily reliant on the monitoring function of independent directors. In the United States, the Sarbanes-Oxley Act of 2002 (SOX)3 provided for the establishment of an audit committee comprised entirely of independent directors. In addition, the NYSE, NASDAQ, and AMEX listing standards introduced a requirement that the boards of public companies-with the notable exception of corporations with a controlling shareholder holding a stake of 50% or higher-must have a majority of independent directors.4

In Europe, building on the U.K. experience,5 in 2005 the European Commission issued a non-binding recommendation on the role of non-executive or supervisory directors of listed companies and (supervisory) board committees,6 prompting the presence in the board of a sufficient number of committed non-executive or supervisory directors "who play no role in the management of the company or its group and who are independent in that they are free of any material conflict of interest."7 Subsequently, in line with the Commission's recommendation, almost all corporate governance codes adopted at EU Member State level recommend that the board include a minimum number or a ratio of independent directors.8

However, in the wake of the financial crisis, the independent monitoring board model has come under attack. It has been blamed for contributing to the crisis, since the independent monitoring board model is claimed to have made it difficult for financial institutions to find independent directors with an adequate level of expertise in their industry, thereby reducing the overall competence of the board.9 In spite of these criticisms, directors' independence is still regarded as a key element within issuer corporate governance, and is widely acknowledged by corporate governance rules and principles, which continue to place their trust in board independence as a useful tool to limit the negative consequences of agency problems affecting corporations.10

Nevertheless, the inability of independent directors to play an active role in preventing a large number of financial scandals and related corporate failures has highlighted the limits of the formal approach to directors' independence "that takes into account only a corporate director's relationship with the corporation and not the tools a director needs to achieve substantive independence."11 Those shortcomings prompted corporate governance experts to reconsider the very function and notion of directors' independence, and stimulated an intense debate about what directors' independence actually means, and how it can effectively improve issuer corporate governance.12

Although the debate is still ongoing and some are still skeptical about directors' independence as a regulatory tool,13 a key point has been already made. Some divergences persist within the global convergence on independent directors.14 In particular, the definition of independence and the role of independent directors are not universally defined, as they largely depend on ownership patterns, industry structure and regulatory goals.15 While the main agency problem in diffusely owned firms is opportunism on the part of the management, and independent directors are required to protect the interests of the shareholders vis-a-vis the management, in controlled firms independent directors are mainly called upon to protect minority shareholders vis-a-vis the controlling shareholders. …

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