7.3 Independence

Although the board of directors aids in solving the principal-agent problem, it does not entirely eliminate the problem. Like members of management, directors could take advantage of their positions of trust for their own personal gain at the expense of shareholders. They could also collaborate with management for their mutual self-interest or could serve the needs of management instead of the shareholders. Unless board members are truly independent of the company and its executives, they cannot act in the best interest of shareholders. For this reason, there are rules of independence promulgated by the SEC and both the NYSE and NASDAQ that must be followed as well as best practices that are encouraged.

The NYSE considers a director to be independent only if "the director has no material relationship with the listed company." Specifically, a director is not independent if the director or his or her family member:

• Has been employed as an executive officer of the company within the last three years.

• Has earned direct compensation in excess of $120,000 (outside of board fees) from the company within the last three years.

• Has been employed as an internal or external auditor of the company within the last three years.

• Is an executive officer at another company where the listed company's present executives have served on the compensation committee within the last three years.

• Is an executive officer at a company whose business with the listed company has been the greater of 2 percent of gross revenues or $1 million, whichever is greater, within the last three years.

Obviously, not all potential conflicts of interest are addressed by these rules. It is impossible to anticipate all potential conflicts of interest. As an example of a board member who was not independent, let's refer back to the Tyco case:

In 2002, CEO Dennis Kozlowski was charged with enterprise corruption and grand larceny for allegedly stealing $170 million from Tyco and obtaining $430 million through the fraudulent sales of securities. With this money, Mr. Kozlowski purchased yachts, art, jewelry, apartments, and vacation estates, and invested in personal business ventures, trusts and other investments. The pattern of improper and illegal activity occurred for at least five years prior to June 3, 2002, when former CEO Dennis Kozlowski resigned. While much of this activity was concealed from the board, it was alleged that one member of the board knew about some of these activities and actually received a fee of $20 million for involvement in one of Tyco's transactions.

Unfortunately, there is little consensus among experts about what standards constitute best practices. For this reason, the NYSE recommends that boards consider all relevant facts and circumstances when making independence determinations. The NYSE encourages boards to assess the materiality of a director's relationship with the listed company from two different perspectives; from the standpoint of the director and from the standpoint of organizations or persons with which the director has an affiliation. The NYSE does not consider the ownership of a significant amount of stock, by itself, as an obstacle to independence. In fact, board members are usually urged and even required by some boards to hold a minimum amount of stock in the company. Many people believe that if directors have "skin in the game" (stock ownership) they will be more aligned with other shareholders and will want the long-term success of the company. In assessing the independence of directors, the board should consider a director's sources of compensation in determining independence by considering whether the director receives compensation from an entity that might impair his ability to make independent judgments about the listed company's executive compensation or other decisions. Similarly, the board should take into account any potential affiliate relationships a director has with the company or its subsidiaries. In doing so, the board should determine whether the relationship places the director under the control (direct or indirect) of company management or impairs the director's ability to make independent decisions about the company's strategy or executive's compensation.

One of the best independence practices and one where boards are currently being pressured by outsiders such as shareholder advocacy groups and activist investors is to appoint an independent chairman of the board (a chairman who is not also the CEO). Many experts argue that an independent chairman is able to act as a counterbalance to the CEO. Experts also tend to discourage "interlocked" boards (where an executive from Company A serves on the board of Company B while an executive from Company B serves on the board of Company A). Some experts argue that these directors lack independence due to social ties. However, others argue that interlocked boards have the potential to help a company due to networking connections. Each year every director of all public companies must state whether or not he or she is independent. That determination is usually made by the corporation's legal counsel based on a lengthy independence questionnaire that each director and officer completes annually.

Directors who not disclose relationships with the company that could impair independence are usually dismissed from the boards they serve on. As an example, consider the following that occurred on one board on which the author served:

Director A was a great director who had served on the company's board for over 10 years. He was always engaged, prepared and made tremendous contributions to the company. However, he was also a principal investor in a money management company that managed approximately $500 million of the company's cash. This relationship was not disclosed by him when he completed his director and officer independence questionnaire. When this information came to light, the other board members swiftly voted him off the board, stating that board members who pretend to be independent but who are really not compromise the integrity of the board.