United States: Faux Board Gatekeepers: Are Independent Board Leaders Just Window Dressing?

Are corporate boards awash in faux gatekeepers? This article, Board Gatekeepers, from a law professor at the University of Wisconsin, begins with a catalogue of infamous board failures to act as effective monitors of company conduct—including, in one case, a nascent scandal that continued for 11 years and another the subject of a successful Caremark claim. As framed by the author, the board plays a critical role, serving on behalf of the shareholders—and now perhaps also other stakeholders—to "ensure that the executive team is acting in the company's best long-term interests," in particular, "to 'set up guardrails for the CEO'—that is, protect shareholders (and stakeholders) from corporate malfeasance." Given the "structural power" that CEOs typically hold in the boardroom—such as through control over information and renominations—courts, regulators and investors often look to independent directors to act as a check on that power. Investors and regulators have also sought to address this power imbalance within the boardroom by introducing two key independent leadership roles—an independent board chair and a lead independent director. One or both of these "board gatekeepers" are now regular fixtures on boards, intended to add a "second layer of protection to the independence of the board" and signal and ensure "the existence of proper monitoring of management by the board." The proliferation of these board gatekeepers, the author contends, "should have cemented board independence in what one can term its functional form: the ability to serve the crucial gatekeeping role that has been demanded of it." But the inventory of recent scandals calls that conclusion into question. Are board gatekeepers really just window dressing?

The article examines board gatekeepers' independence and powers in 900 publicly traded companies to assess their "functional independence." The author finds that many gatekeepers viewed as independent "are tightly connected to the companies in which they serve in ways that cast doubt on their willingness to truly act independently." In addition, he concludes, board gatekeepers often lack "concrete tools...to exert independent monitoring," highlighting the concern that gatekeepers may not have the types of substantive enumerated powers that would allow them "to truly act independently even if they are willing" and to permit accountability for failures notwithstanding appropriate powers. Are the positions of independent board chair and lead independent director more ceremony than substance? The author advocates that gatekeepers' functional independence be safeguarded "through a combination of heightened independence standards, improved disclosures, and the grant of specific and common enumerated powers."

SideBar

One of the scandals cited by the author related to the tragic 2018-19 crashes of two Boeing 737 Max aircraft. In In re The Boeing Company Derivative Litigation, the question before the Court was whether the plaintiff stockholders—New York and Colorado public pension funds—had adequately alleged, under In re Caremark International Inc. Derivative Litigation and Marchand v. Barnhill, that, as a result of the directors' "complete failure to establish a reporting system for airplane safety," or "their turning a blind eye to a red flag representing airplane safety problems," the board faced a "substantial likelihood of liability for Boeing's losses." The Court concluded that the answer was yes—on both bases. (See this PubCo post.)

The author also highlights the fact that, in 2018, prior to the first crash, Boeing received three governance-related shareholder proposals, one requesting an independent board chair. All of the proposals named well-known activist John Chevedden as proxy. Two of the supporting statements suggested that the long tenure on the board of the company's lead director "can make him a lap dog Lead Director." The other supporting statement, referring to the company's two CEO directors, observed that "CEO directors can tend to be lap dog directors for a fellow CEO." While the company did not object to including any of the proposals, it did object to the reference to some of its directors as "lap dogs," characterizing the term as a "baseless character attack" that, quoting a note to Rule 14a-9, "directly or indirectly impugn[s] character, integrity or personal reputation." The company contended that the term "lap dog," defined by Webster's as "servile dependent or follower," implied, "with no factual basis whatsoever," that the directors lacked "independence and reflexively follow[] the dictates of others." The staff disagreed, and did not allow exclusion of the requested portions of the supporting statements. Now, to be clear, the proposals didn't actually accuse the directors of being "lap dogs" at precisely that moment. Rather, they were artfully worded to imply that, in light of tenure concerns, the lead director was a likely candidate for canine status or, similarly, crafted to malign the entire category of directors that are also CEOs, implying, without expressly charging, that these lap-dog traits may well apply to the company's CEO directors. (See this PubCo post.)

Historically, the author observes, corporate boards served a primarily advisory role, but that role has expanded for modern boards, which are tasked with monitoring company management, participating in key managerial decisions, such as mergers and stock issuances, considering stakeholder demands (recently) and providing strategic guidance to management. The board also plays an important role with respect to risk oversight, and the courts have made that plain in a series of recent Caremark cases. (See this PubCo post.) To ensure the effectiveness of their monitoring function, investors, courts, legislators and regulators expect that boards are largely independent, "with an emphasis on director tenure and board leadership" as key issues.

However, the author contends, directors may be designated independent, but not be "functionally independent." Factors such as director interlocks, "information capture" by management or long board tenure may sometimes lead to a compromise of their functional independence, with the result that the development over time of shared social connections might bias them or taint their objectivity. (See this PubCo post and this PubCo post.) While external gatekeepers are often effective gatekeepers, the author asserts that they may have inherent conflicts of interest because they are paid by management. As a result, "investors and regulators have increasingly turned toward the board to fulfil an internal gatekeeping function." Specifically, independent board chairs and lead independent directors have emerged to serve as "guardians of independence within the boardroom."

Historically, CEOs served as the board chairs, but today, many large companies instead have selected an independent director to serve as board chair, either on their own initiative or as a response to investor pressure, including through numerous shareholder proposals—as a way to address potential conflicts and other governance concerns. The article reports that, "in 2019, the majority of S&P 500 boards have split chair and CEO positions, compared with only thirty-seven percent a decade ago." Likewise, LIDs have also become increasingly prevalent, and "nearly 58% of S&P 500 companies have appointed an LID, and the vast majority of companies that have resisted implementing an Independent Chair have at the very least instituted the position of an LID." In part, the prevalence of LIDs on some boards may reflect the NYSE listing requirement that outside directors hold regular executive sessions, overseen by a "presiding" director. Because LIDs are often "not officially mandated," companies have more liberty in structuring the position and selecting which powers to grant LIDs, essentially through private ordering. As a result, the author observes, companies have been able to self-determine

To identify issues regarding gatekeeper independence and powers, the author analyzed "hand-collected data of all S&P 500 companies, as well as a random sample of 200 mid-cap S&P 600 companies and 200 small-cap Russell 3000 companies."

Lids. As noted above, LIDs have increased in prevalence. According to the article, in 2017, only 11% of companies in the S&P 1500 had neither LIDs nor independent chairs, compared to 33% in 2009. And in 2020, for companies in the S&P 500, only 14 boards did not have either independent chairs or LIDs. Indeed, companies in the S&P 500 appear to prefer having LIDs (61%) rather than independent chairs. However, "because companies choose when to designate an LID... [t]his essentially allows the company to choose when the heightened monitoring that an LID theoretically provides is necessary."

According to the article, only 7% of companies disclosed required LID qualifications, and most required that LIDs be "independent" only within the meaning of the applicable listing standards. Companies typically do not impose heightened independence requirements for the role of LID, which can result in the appointment of LIDs with "close ties with company operations and management," nor do companies typically regulate LID tenure. A number of companies cited by the author had LIDs that had served on the board for decades and some had served as LIDs for well over 10 years. The author observes that "[l]ong tenure has been increasingly deemed to reduce a director's independence, [and this] concern is even more important when applied to a key gatekeeper such as the LID." In addition, "an overwhelming majority of LIDs are white men," the author observes, "and the lack of diversity in leadership roles in the boardroom could be indicative of social bias, and an old boys club atmosphere that could prevent independent thinking, inquiry and monitoring."

SideBar

As discussed in this article in the WSJ, several years ago, some academics and institutional investors began to question whether, after a long tenure on the board, an "independent" director is really still independent, especially when the director is a retired CEO or C-suite executive from another firm. Of course, they're not talking about independence in the technical sense of the NYSE or Nasdaq definitions; rather, the concept here is more in the nature of "social independence." One concept of "social independence" was described in the academic paper "Seven Myths of Boards of Directors," as based on "education, experiences, and upbringing—positing that people who share social connections feel psychological affinity that might bias them to overly trust or rely on one another without sufficient objectivity." In the paper, the authors discuss a study of directors of Fortune 100 companies between the years 1996 and 2005, which showed that the absence of "social independence" is "correlated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulates earnings to increase his or her bonus. They conclude that social relations compromise the ability of the board to maintain an arm's-length negotiation with management, even if they are independent by NYSE standards." (See this PubCo post.) According to the WSJ, long board tenure, together with the rise in the appointment to boards of retired CEOs or other C-suite executives from other firms, is giving rise to a new class of director: the "new insider." One academic cited in the article speculates that the "increasing use of board members who serve for longer periods and come with a predisposed background as corporate insiders elsewhere is not accidental, but is in fact an effort on the part of companies to import the benefits that an 'insider' board would have produced." (See this PubCo post.)

For the analysis of LIDs, the author identified 37 "common" powers that enable LIDs to "robustly" fulfill their intended roles, such as agenda oversight and CEO succession planning, and identified any limitations or qualifications. Based on the level of responsibility involved, the author then classified these powers as strong (crucial to the LID's ability to guide the board and enhance communication, such as presiding at all board meetings in the absence of the chair and leading the evaluation of the chair's performance), medium or weak (such as facilitating communication generally or provide feedback to the CEO or senior management). Each LID power was then analyzed based on "1) How 'qualified' the language of given power is; 2) Whether that power resides solely with the LID; and 3) Whether that power is 'active' or requires a triggering event to be exercised."

Based on his research, the author contends that many LIDs have not been granted adequate enumerated powers; in essence, "LIDs may have essentially become 'lead' in title only." The author contends that the powers accorded to LIDs are often too limited to allow them to be effective in safeguarding board independence. For example, ISS identifies the following as key duties that should be assigned to LIDs: "serving as liaison between the chair and the independent directors; approving information sent to the board; approving meeting agendas for the board; approving meeting schedules to assure that there is sufficient time for discussion of all agenda items; retaining the ability to call meetings of the independent directors; and, if requested by major shareholders, being available for consultation and direct communication." While many boards delegated these powers to LIDs, the author observes, the powers were often qualified or limited. For example, 57% of the powers granted to LIDs were "nonexclusive," that is, instead of granting the LID the ability to approve the board agenda, the LID can only advise the chair about the agenda. In addition, a number of powers were dormant (i.e., require a trigger to be effective). Of the 37 LID powers identified in the article (Appendix A), the "most common (76%) was the ability of the LID to preside at executive sessions of the Independent Directors. The other most prevalent granted powers pertain to setting the structure and content of board meetings and serving as a liaison between insiders and other directors. Conversely, the least prevalent powers concerned more substantial delegations of authority, such as assisting in determining when to relax securities requirements and deciding to direct specific matters to the Audit Committee." In addition, there are a "handful of critical powers crucial to the role of an LID that are rarely granted like participating in Chair evaluation or the ability to call special board meetings."

The author's analysis of the number of strong powers allocated as a percent of total powers revealed that, on average, 68% of all powers allocated to LIDs authorize them to act in a way that maximizes their role as a gatekeeper....However, out of twenty potential strong powers or responsibilities identified, LIDs within the S&P 500 are allocated on average only 4.5 strong powers." The author also showed that companies that had granted fewer powers were "most likely to materially qualify the powers allocated. On average, when a company allocates only four powers to an LID, at least two of those are qualified in some way limiting their ability to act on their own volition. In comparison, companies with higher [numbers of powers granted] not only grant more powers in general but are less likely to materially limit a majority of those granted powers. This is particularly important, as it means that LIDs with few powers are further [hamstrung] by having these enumerated powers weakened by limiting or qualifying language. This creates an entire subset of LIDs that are 'Lead' in title only."

Independent chairs. According to the article, 51.5% of companies in the S&P 500 have independent chairs and about 45% of the companies with LIDs also have independent chairs. Of course, boards are typically required to have a chair—the question is what type of chair? Although companies have increasingly split the positions of chair and CEO, as of 2019, 21% of companies in the S&P 500 had separate chairs and CEOs, but the chair designated was not independent, perhaps also serving as CFO or perhaps a former CEO designated as independent (a designation which the author questions, given a former CEO's likely tenure, equity stake and connections). Here, as well, the issues regarding independence that affect LIDs also affect the designation of board chair.

Similar to LIDs, the author found that powers designated to independent chairs are often materially limited, especially for companies that have granted fewer powers. The most common powers granted are the authority to approve or set board agendas and to preside at executive sessions of the independent directors. The author characterizes these powers as "largely supervisory"; however, the "least common powers, in comparison, are those that are more active and grant the Independent Chairs the authority to act in a non-supervisory manner, such as evaluating members of the Board and retaining independent advisors."

To gain additional insight, the author also conducted a number of interviews with directors and general counsel. The interviews tended to affirm the importance of board gatekeepers. Granting explicit powers was viewed as important, particularly in preventing future disputes about the extent of their authority or encroachment on their authority where boards were divided.

Recommendations. The author concludes that, although some companies do grant their independent chairs and LIDs a "number of significant powers, in many other instances, the data invokes a concern of window dressing. Granting a broad range of superficial powers may convey a false sense of trust to shareholders, while leaving the gatekeeping post unmanned. To be effective, an Independent Chair and/or LID must have powers sufficient to act, not merely to observe. Yet, the data show that in many companies, a majority of powers granted to both Independent Chairs and LIDs are of a relatively procedural nature.... These board gatekeepers, even when operating under a veneer of authority, may be materially limited in the utilization of their powers." This concern is only compounded, the author contends, "by the reality that many LIDs and Independent Chairs, may not be independent at all."

The author advocates changes in how board gatekeepers are "designated as independent, in how independence is disclosed and perceived, and in how these key independent gatekeepers are equipped to carry out their intended role." While some of the author's suggestions may seem a bit, let's say, impracticable, companies may want to revisit their bylaws or governance guidelines to reassess the standards and powers applicable to board gatekeepers.

Designation. First, he encourages companies to "set clear and transparent criteria for determining independence," which go beyond the minimum threshold requirements for director independence set forth in exchanges guidelines. While these criteria should be tailored for each company, he first suggests that, to avoid potential conflicts, board gatekeepers should be discouraged from serving on other boards, especially boards of companies in the same industries or, at a minimum, directors' ties to other companies should be considered. Second, directors' previous ties to management, roles as former managers of the company and long service on the board "should, at a minimum, raise flags as to their functional independence." Companies should also consider capping the tenure of directors in their roles as board gatekeepers. Third, he recommends that the compensation of these gatekeepers "be decoupled from that of management" by, for example, "increasing the base pay component of their compensation package, as well as long term equity grants that are only exercisable several years after their departure." The author also suggests that stock-exchange mandated cooling-off periods for determining independence of former CEOs—especially those with long tenures in that role—may not suffice.

Disclosure and perception. To allow investors to assess the independence criteria set by the company, the author recommends that companies disclose the criteria applied, along with the board analysis undertaken to determine independence. Some other ideas floated by the author: providing a comparison of its criteria against those of its peer groups (because studies have shown that benchmarking has a ratcheting effect), and consider soliciting a non-binding "say on independence" vote.

Functional independence. According to the author, the inability of board gatekeepers to effectively carry out their roles as "guards of the guards"—especially when a CEO or former CEO is the chair—is attributable to limitations on their capacity to obtain and leverage independent information and to companies' seeming reluctance to provide LIDs with substantial practical delegations of authority. Accordingly, he advises, investors and regulators need to "re-think the specific functions of the LID role," perhaps by formalizing the "approach to allocating powers that is consistently applied across companies." The author points to a couple of large companies as exemplary: each company "allocated over twenty powers with at least seven of those powers being strong. They each only had one qualified power, which limited the LID's ability to communicate directly with shareholders as appropriate or as requested. Additionally, the powers allocated to gatekeepers in these two companies are clearly defined and listed within each company's corporate governance guidelines, as well as prominently displayed on their investor relations page." In the author's view, "[o]nly once independent directors are given powers that are exercisable and provide them with the necessary tools to carry out their intended role—ensuring the independent of the board as a whole—will the 'independence' title granted to these key figures [be] restored. And, once it is restored, courts can rightfully grant the appropriate deference, and investors' sense of trust can be restored in both the designation process and the safeguarding of their interests."

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