Speech by SEC Commissioner:
Board Independence and the Evolving Role of Directors
26th Annual Conference on Securities Regulation and Business Law Problems
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
February 20, 2004
Good morning. I would like to thank the University of Texas School of Law for inviting me to speak here this afternoon. I am pleased to participate in this program, especially because it includes Hal Degenhardt and Denny Crawford. Denny and Hal are two individuals who deserve all of our thanks for their tireless work on behalf of investors. The securities markets are better and safer for investors because of their vigilance and hard work.
Before beginning, I need to give the standard disclaimer: that is, the views I express today are my own, and not necessarily those of the Commission or its staff.
While the conference overall is focused on Securities Regulation and Business Law Problems, a number of sessions are directed specifically at issues surrounding directors and corporate governance. I want to pick up on the theme of corporate governance, since it is hard to think of a more pressing business law problem. As those of you with corporate clients know, when it comes to governance reforms, officers and directors probably feel like the defenders of the Alamo did as they faced Santa Anna's onslaught. Hopefully for them, and indeed for all of us, there will be a different outcome in the current context. As attorneys, many of you will play a large part in helping companies implement the reforms to avoid that outcome.
There is no doubt that Sarbanes-Oxley changed the way corporate America approaches governance. As important as the specific requirements in Sarbanes-Oxley are the introspection and change in attitude it requires. Corporate officers now have to recognize that good corporate governance is key to any long-term business strategy, and that transparent public disclosure is one of the most important jobs for a public company officer. Recent events demonstrate that a greater number of CEOs who fail to recognize this are being shown the door - and some will see the inside of a jail cell.
The people in this room spend a lot of time dealing with corporate officers and directors, and counseling them on how to meet their obligations. Today, I would like to address a specific governance issue dealing with the evolving role of directors, and determining how much "independence" on a Board is a good thing. There has been a tendency lately to push for more and more "independent" directors as part of the solution to every corporate governance problem. Some have treated director independence as a substitute for other critical qualities of directors, such as experience, knowledge, and diligence. In the mutual fund context, I recently expressed doubts as to whether simply increasing the number of independent directors - as "independent" currently is defined - is putting form over substance. We need to ask some fundamental questions that have not received much attention during the recent debate. For example, what is the goal we hope to achieve by increasing independence, and is it consistent with the role of directors? I would also like to talk about the important responsibility lawyers have under our governance reforms to make sure that Boards and independent directors can carry out their evolving role as intended.
I. Director Independence in Corporate Governance
Independence plays an important role in corporate governance, but is a fairly recent addition to the governance framework. While it has been discussed for over 60 years, much of the recent push for greater outside representation on boards started in the 1970s. As we examined various corporate scandals that had occurred, director independence increasingly was seen as a missing element necessary to position the Board to oversee management, foster integrity and prevent such misbehavior from recurring.1
Since the 1970s, we have crept gradually towards mandating greater and greater independence on boards of directors.2 Increased director independence is often treated like the silver bullet that will prevent future misconduct - or even managerial inefficiency. But at each point along the path, the heightened independence of the Board has failed to prevent subsequent crises, and the evidence is inconclusive regarding whether there is a correlation between independence and performance. But each time a crisis erupts, we keep going back to the well for just a little bit more.
At some point we need to ask some fundamental questions. What is the Board's role? Does independence enhance the Board's ability to fulfill its intended functions? Do we expect the Board of directors to prevent misconduct and, if so, why have increasingly independent Boards and committees failed to do so? And how does the evolving role of directors affect the way lawyers need to counsel their corporate clients?
II. The Board's Evolving Role
The main reason the structure and independence of Boards has changed is that the Board's role in the governance of modern corporations has evolved. In the not-so-distant past, directors were viewed primarily as part of management, much more involved in corporate decision-making on a whole range of issues.3 This "Board as management" paradigm was codified universally in state corporate codes, which provided in one form or another that the business and affairs of the corporation "shall be managed by or under the direction of a board of directors." Under this model, it was not uncommon for the Board to be controlled by insiders who had the necessary knowledge, experience and in-depth involvement to make informed managerial decisions. Accordingly, with the limited exception of the statutory independence requirement for mutual fund boards, neither state nor federal law imposed any structural constraints on Boards or their committees.4
More recently, and especially since the 1970s, we increasingly have asked the Board to serve as a check on management to protect shareholders, and have been willing to impose structural requirements to further that goal.5 This conception of the "Board as monitor" understandably has gained renewed momentum as a result of recent scandals involving "imperial CEOs." In the recent scandals, the chief executives often seemed to be unchecked, running the companies as their own personal fiefdoms. As the directors' role has evolved, they are expected to ensure not only that operations are efficient and that performance is maximized, but also that the company and its management are behaving like good corporate citizens. In the role of monitor, directors with close ties to the company's management understandably are seen as unfit to fulfill monitoring obligations, for the same reason the proverbial fox can't be trusted to guard the henhouse. As a result, our rules have tended towards the other end of the spectrum of trying to decrease management's influence over the Board.
A. Implications for Regulatory Policy
From a regulatory perspective, I think most people would agree that some degree of independence is a necessary, but not sufficient, part of good corporate governance. But how much independence is necessary or desirable? And what does the evolving role of the Board mean as a practical matter in terms of our formulating policy and your advising your clients? There are at least three general lessons that I believe we should take from our experience with structural Board reforms.
The first thing we need to recognize is that the role of the Board necessarily evolves over time with changing circumstances. At any point in time, neither paradigm of the Board - as manager or monitor - is likely to provide a completely accurate picture. Practically speaking, Boards always have, and always will, simultaneously serve both managerial and monitoring functions. The goal of our regulatory reforms should be to make sure both the roles are appropriately accounted for and balanced, and to avoid unnecessarily infringing on either legitimate role.
The second thing we should recognize is that there is an undeniable tension between the dual roles of directors as partners with management in running the company on the one hand, and as judges of management's performance on the other. What do we really want from directors? We want a Board that is collegial, informed and involved enough with management to provide strategic guidance. We also want a Board that is far enough removed to ask tough questions and take decisive independent action when necessary. That is a tall task, to say the least. And, unfortunately, something gets lost when we try to translate that fairly straightforward job description into regulatory policy.
Which leads to the third thing we need to recognize. Namely, there is no single model of the "effective corporate board." The proper balance between the paradigms of the Board as manager versus monitor will differ depending on a number of company-specific characteristics. These include the industry, size, history, shareholder base, and stage of the company in its corporate life.6 There are companies with conscientious inside directors and Chairmen that have served their shareholders interests extremely well. Conversely, as some of the recent corporate scandals demonstrate, there are many Boards that had the independence characteristics currently in vogue, but failed their shareholders miserably. The mere fact that a company's Board appears less independent than other Boards does not necessarily mean that it cries out for a regulatory "fix."
As regulators, it is sometimes difficult to come to grips with the notion that one-size-fits-all solutions may not be effective in all instances. For over 30 years, we have attempted to use independence as an objective proxy for subjective characteristics we hope directors will possess. But "independent" is not a proxy for "good," especially given our tendency to focus on economic independence, and not independence of thought. It should not be surprising, therefore, that the results of reform efforts have been mixed. The optimal Board structure at one company may be helpful at that company, but unhelpful - or actually counter-productive - at another. Requiring greater independence for all companies in all instances may thus impose significant costs along with the potential benefits. As we consider further reforms, we need to acknowledge and do a better job of accounting for those costs.7
B. Implications for Lawyers
In counseling Boards on how best to fulfill their obligations, lawyers also have to account for the evolving role directors play in corporate governance. Those of you who have been advising corporate clients for a long time have had to change the way you approach the task. But it is also important to look at the situation from your clients' perspective. From a director's perspective, it is an understatement to say that expectations have increased. You should be sure your clients understand that, if they have been on a Board for decades, the job today is likely to be significantly different than the one they first bargained for.
Part of counseling your clients on how to do the job right also means that you need to make sure they understand that, although it is appropriate to rely on management, they should not accept being spoon fed whatever management wants them to hear. You should advise them not to be rushed into making important decisions when it is not absolutely necessary. A Board consisting of a majority of independent directors has the tools necessary to effect substantial change within an organization. The independent directors can request information from management, require that certain items be placed on the Board's agenda, remove uncooperative management-directors from the Board through their control over the nomination process, and elect an independent chairman if they deem it necessary. Used properly, those powers are quite significant. And you can play an important role in making sure those powers are used properly.
I must admit that it has been disappointing to hear independent directors assert that they didn't know about flagrant and widespread instances of misconduct in their companies. The claim is often that they did not have the right information, were too removed to know what was going on, or were lied to by management. If that is the case, then I am not sure that simply increasing the number of independent directors will be real helpful. In the broad scheme of things, having eight bumps on a log is not much better than having six.
Fortunately, Sarbanes-Oxley and our rules include a number of provisions designed to empower independent directors, make them more effective in their oversight function, and provide additional channels for information about the company that do not rely on management. These include procedures for receiving anonymous tips on fraud, protection of whistleblowers, meetings with auditors outside management's presence, and required reports on internal control deficiencies.
Importantly, the law also requires that audit committees have the authority to hire advisers who are independent of management and the auditors. As such, under the Sarbanes-Oxley framework, independent advisers - including lawyers - can play a key role in helping directors carry out their monitoring responsibilities. Independent advisers can help ensure that Boards and their committees ask the right questions, and get the information they need to make informed decisions. That is not to say that directors can or should defer to lawyers or other outside advisers. Ultimately, it is the director who must exercise his or her judgment in the best interest of shareholders. Legal advice is important, but is no substitute for that judgment. However, you can be helpful in determining what information might be germane to a particular issue, and, as appropriate, in helping to gather and analyze that information.
The changing paradigm for directors also affects the way lawyers need to approach their job. What is true for directors who are expected to serve as monitors is equally true for the lawyers who advise them. You have to be independent-minded enough to rock the boat on occasion, and you can't be afraid to point out that the Emperor isn't wearing any clothes. A law firm hired by management to do a substantial amount of work - or that hopes to develop that business in the future - should carefully consider whether that work might interfere with its ability to advise directors effectively. Directors obviously need to take the lawyers' ties to the company into account in deciding if they are appropriate advisers for the Board in carrying out its monitoring function. But lawyers also need to evaluate their own independence in deciding whether to accept an engagement. You should decline an engagement if you do not think you can perform it consistent with the spirit of Sarbanes-Oxley.
Another important aspect of the Sarbanes-Oxley reforms is the Commission's lawyer rules. Our rules reinforce the truism that a lawyer who represents a corporation owes an ethical obligation to the company, and not to individual managers or directors. Although the rules are directed at lawyers, they serve to further empower directors by making sure the directors get critical information needed to oversee management. In that role, there arguably is no more important information to a director than knowing about evidence of a material violation.
As I am sure you are aware, under our "up-the-ladder" reporting rules, lawyers have an obligation to bring evidence of material misconduct to the attention of someone within the company who can do something about it. Lawyers who practice before the Commission have an important gate keeping function, and in that role have to foster trust and respect for the law. A lawyer who stands by while those engaged in illegal activity do grievous harm to the company and its owners, fosters contempt for the law and the legal profession. Our rules require that lawyers faced with evidence of a material violation take appropriate action, or be held accountable for their failure to do so.
Which brings me to a final thought. There is one thing that has not changed - which is that lawyers who advise corporate Boards should help them meet the letter and spirit of their fiduciary obligations. A lawyer who advises corporate clients on the minimum necessary for compliance, or with a focus exclusively on how to avoid liability, does a disservice to his clients and the shareholders they represent.
In conclusion, the debate over issues of Board structure and other important areas of corporate governance is sure to continue. From the investors' perspective, the job of directors has evolved, and the will to do it right is as important as a director's paper qualifications or business acumen. I assume that most directors out there are very capable people, but if they are not willing to challenge management when appropriate, then they do not meet an important characteristic of the modern-day director.
Similarly lawyers can play an important part in helping directors fulfill the evolving and expanding expectations, but only if they are truly independent in giving their legal advice. Some of the fact patterns arising out of the recent corporate scandals have been discouraging, to say the least. In some instances, lawyers who were in a position to prevent misconduct failed to do so. In other instances, they facilitated and even actively participated in fraudulent activity by structuring transactions whose clear intent was to mask a company's true financial condition, or by passing on their purported legality. In the wake of the scandals, many companies and financial intermediaries are taking a hard look at the way they do business to avoid such questionable dealings in the future. The legal community needs to engage in a similar exercise.
The fate of the Alamo defenders was sealed once they made their decision to stand their ground. Despite their heroism, by almost every measure the odds against them were too great to be overcome. The situation facing the modern-day director - and the lawyers who advise them - is not nearly so desperate. While the job expectations have evolved, and while directors need to adjust and adapt, they have the tools necessary to demand and implement good management and corporate governance. You can help them achieve that goal. The one absolutely necessary ingredient - and the one we cannot regulate - is the will to meet that challenge.
Thank you very much. I would be happy to take any questions.