While director independence has become a topic of global importance, the definition of independence and the role of independent directors remain unsettled, depending largely on ownership patterns, industry structure, and regulatory goals. 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 shareholders vis-à-vis the management, In controlled firms, however, independent directors are mainly called upon to protect minority shareholders vis-à-vis controlling shareholders. Therefore, in a context of concentrated ownership, independent directors are mainly responsible for vetting operations involving conflicts of interest and preventing tunneling by controlling shareholders.

Bebchuk and Hamdani[1] have shed new light on directors’ independence at controlled companies by providing an analytical framework that seeks to make independent directors more effective in performing their oversight role. They convincingly argue that some independent directors should be accountable to public investors who, in order to achieve this aim, should have the power to influence the election or retention of several “enhanced-independence” directors.

Starting from this persuasive outcome, and adopting a comparative and functional analysis, in a recent article I extend the Bebchuk and Hamdani framework in several directions to make it more effective and adaptable to different jurisdictions. To be sure, allowing minority shareholders to play a role in the election and retention of a minority of directors is essential to enhancing the independence of these directors and making them more accountable to public investors. Nevertheless, it remains doubtful whether providing public investors with influence over the election and retention of some directors will be enough to promote truly independent and objective conduct by these board members.

Especially when minority shareholders are allowed to appoint some independent directors, potential apathy on the part of minority shareholders could lead to their failure to participate in directors’ elections and consequently limit the practical relevance of enhanced-independence directors. In addition, it seems that the effectiveness of the Bebchuk and Hamdani proposal may depend on the type of public investors supporting the election of enhanced-independence directors. In particular, since a purely activist-driven approach could present some drawbacks and, especially, the central role of activist hedge funds may raise some concerns regarding the effectiveness of enhanced-independence directors as monitors acting on behalf of all minority shareholders, alternatives aimed at stimulating and favoring the involvement of institutional investors in the election of enhanced-independence directors should be developed.

In my paper, I argue that there should be greater involvement of non-activist institutional investors in the selection and election of enhanced-independence directors. For example, based on an extensive comparative analysis, I argue that a process such as the Italian system of slate voting, which allows minority shareholders to appoint at least one board member, coupled with the coordination role performed by non-profit associations representing institutional investors, might foster greater involvement by institutional investors in the appointment, reelection, and termination of some enhanced-independence directors and make them more effective in reducing the agency costs affecting controlled companies. Similarly, in the U.S., the Council of Institutional Investors might perform a coordination role in order to promote the participation of institutional investors in director elections and the appointment of minority-supported candidates.

In addition, to induce independent directors to perform their oversight function in a truly independent way, the formal approach to independence prevalent in much of the world should be replaced with a regulatory strategy of providing directors with incentives to act independently. One challenge involves reducing the influence that controlling shareholders may have over independent directors as the result of personal and business ties. Greater consideration should be given to the human dynamics of corporate boards and to measures aimed at preventing the decisions of enhanced-independence directors from being distorted by behavioral biases—including group-think. In particular, within a context of concentrated ownership, laws should promote unbiased decisions by independent directors on transactions that are influenced by controlling shareholders.

First, term limits for enhanced-independence directors is recommended, as a long tenure may intensify structural biases and social ties, which could also affect the conduct of these directors. Second, enhanced-independence directors should be granted full access to relevant information concerning transactions with controlling shareholders. Third, more extensive disclosure of the enhanced-independence directors’ views would facilitate public scrutiny of their decisions. Increased disclosure would expose independent directors to reputational risk when their decisions or opinions were perceived to be insufficiently objective,. That risk could ensure that the decisions of independent directors are more aligned with the views of appointing investors than with those of management, thereby increasing the quality of monitoring.

ENDNOTE

[1] https://scholarship.law.upenn.edu/penn_law_review/vol165/iss6/1/.

This post comes to us from Giovanni Strampelli, associate professor of business law at Bocconi University, Milan. It is based on his recent paper, “How to Enhance Directors’ Independence at Controlled Companies” forthcoming in the Journal of Corporation Law and available here.