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There needs to be greater scrutiny of director independence – what it means and who decides

This will get legal and technical very quickly in the first few paragraphs, but please bear with me. Director independence is an important area and worth blogging about.

Currently, if a director has no direct or indirect “material” relationship with the company, that director will be independent. Whether a relationship is “material” is a relationship that could, in the view of the board of directors, be reasonably expected to interfere with the exercise of that director’s independent judgment.

A board determining director independence is a subjective view, i.e., the view is based on the board’s judgment. The board’s judgment need not be objectively reasonable, which is otherwise known as a “reasonable person” standard. Also, there may not be a line of analysis that could reasonably lead a board from the factors it considered to the conclusion it reached.

After the 2008 financial crisis, the Ontario Securities Commission (OSC) attempted to introduce a reasonable person standard for director independence, by stating that boards should “have regard to all relevant circumstances” in their analysis, and that a director should not have a relationship with the company or its management that could be “reasonably perceived” to interfere with that director’s independent judgment.

These amendments were strenuously resisted on grounds it would limit the director pool, and that outsiders lacked the collective experience and specific knowledge of the director in question.

The OSC has yet to address this issue of director independence.

If a director is conflicted or his or her independence is compromised, the board should not be the sole arbiter of this. Directors are a small group, subject to group dynamics and peer pressure, and should not be immune from external scrutiny of perceived conflicts or of compromising of independence that incorporate best practices. Conflicts of interest are handled within an organization by people independent of the decision.

Take two good examples of how director independence could be better scrutinized, from an objective point of view: (i) director tenure and (ii) director relationship to a significant shareholder or control person.

Director Tenure

There is a reasonable belief that exceeding a certain number of years on a board promotes greater closeness to management and less objectivity in performing an oversight role of management. The UK for example has a “nine year rule” for all its listed companies, beyond which a director’s continued independence is called into question. There is also a reasonable view that board renewal and diversity of skill sets is a good thing, in that a younger director with a more relevant skill set need not be blocked by a senior director who refuses to retire.

When the UK rule is applied to Canada, several directors fail. Of five chartered banks, for example, thirty (30) directors exceed nine years with several directors on bank boards for almost 20 and up to 25 years. Directorship should not be a lifetime appointment. These directors need to let go and make room for the next generation of directors.

The debate on whether long-serving directors are reasonably perceived to be independent from management, and if so, how, and how the views of their fellow directors have been canvassed, is one worth having, juxtaposed with objective views of scholars, rating agencies, diversity candidates and shareholders on this topic. The UK incorporates both the subjective and objective views.

Director Independence from a Significant Shareholders or a Control Person

Right now a control person or significant shareholder is not disqualified from being independent.

It is equally reasonable that an appropriate proportion (subjectively and objectively defended) of a board be comprised of directors who are independent –subjectively and objectively– from both management and a significant shareholder or control person, if either exists. Numerous Canadian companies have a significant shareholder or control person. (A significant shareholder or control person could own a majority of voting shares and control the directors’ appointment to a board.)

It may also be reasonable to consider the control person or significant shareholder’s nature and degree of involvement or influence over management for purposes of assessing independence.

A related party (insider) transaction can occur such that directors elected by and from the non-significant shareholder or control person may also be reasonable, to oversee such transactions.

Will the debate occur?

Long-serving directors and significant shareholders or control persons have vested interests and their view is worth hearing. It should not be the case however that the debate does not occur or other views are excluded from an unbiased assessment of director independence, what this means and who decides.  It is important to get director independence right as much of corporate governance effectiveness hinges on the independence and ultimate effectiveness of directors.

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