March 08, 2007
The Fetishization of Independence
Posted by Victor Fleischer

Former Glom-Guest-Blogger Usha Rodrigues (Georgia) has posted a great new paper, The Fetishization of Independence.  Here's the abstract:

According to conventional wisdom, a supermajority independent board of directors is the ideal corporate governance structure. Debate nevertheless continues: empirical evidence suggests that independent boards do not improve firm performance. Independence proponents respond that past studies reflect a flawed definition of independence.

Remarkably, neither side in the independence debate has looked to Delaware, the preeminent state source for corporate law. Comparing Delaware's notions of independence with those of Sarbanes-Oxley and its attendant reforms reveals two fundamentally different conceptions of independence. Sarbanes-Oxley equates independence with outsider status: an independent director is one who lacks financial ties to the corporation and is not a close relative of management. Delaware's approach to independence, in contrast, is situational. As different conflicts arise in different contexts, the focus of concern - the influence from which we wish to insulate directors - varies as well.

There are at least two lessons for corporate reformers. First, the definition of independence should be refined to address the conflict at hand. For example, if the area of concern is executive compensation, the question is not merely whether the director lacks financial ties to the corporation and familial ties to corporate executives, but also whether the director lacks financial ties to the executives being compensated. Current independence rules overlook this obvious hole. Second, and more fundamentally, independent directors are useful only in situations where a conflict exists. An independent director - a part-timer whose contact with the corporation is necessarily limited - is not inherently better suited to further the interests of shareholders than is an inside director. Current rules thus over-rely on independence, transforming an essentially negative quality - lack of ties to the corporation - into an end in itself, and thereby fetishizing independence.

This is a great paper.  The corporate governance scandals of recent years have taught us that having an independent board isn't enough to cure all ills.  Rather than blindly strike out against the concept of independence, however, Rodrigues steps back to thoughtfully consider how the concept is applied, inconsistently, in different regulatory contexts.   The paper raises some sticky questions, of course:  there are potential issues with a situational approach; certainty is important; there are advantages to having independence measured ex ante, as a rule, rather than ex post, as a standard, etc.  The normative implications are complicated.  But the descriptive and analytic implications are crystal clear -- our thinking about independence is terribly muddled.  This paper should stop us from treating independence as a end in itself.  And that's surely right.   Right?

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