While directors’ independence has become a common feature of governance all around the world, the definition of “independence” and the role of independent directors are not universally defined: they largely depend on ownership patterns, industry structure and regulatory goals. The main agency problem in diffusely owned firms is opportunism on the part of the management, and independent directors are required to protect the interests of the shareholders vis-à-vis the management. Meanwhile, in controlled firm, independent directors are primarily called upon to protect minority shareholders vis-à-vis the controlling shareholders. Therefore, in a context of concentrated ownership, independent directors are mainly involved in vetting operations involving conflicts of interest and preventing tunnelling by controlling shareholders.
Recently, Bebchuk and Hamdani have shed new light on directors’ independence and effectiveness in controlled companies: they convincingly argue that some independent directors should be accountable to public investors who should have the power to influence the election or retention of several "enhanced-independence" directors.
Starting from this persuasive outcome, and adopting a comparative and functional analysis, in my recent article “How to Enhance Directors’ Independence at Controlled Companies”, forthcoming in the Journal of Corporation Law, I extend the Bebchuk and Hamdani framework further in several directions in order to render it more effective and adaptable to different jurisdictions. To be sure, allowing minority shareholders to play a role in the election and retention of a minority of directors is essential to enhancing the independence of these directors and to make them more accountable to non-controlling investors. Nevertheless, it remains doubtful whether providing public investors with influence over the election and retention of some directors will be enough to promote truly independent and objective conduct by these board members.
Especially when minority shareholders are allowed to appoint some independent directors, potential apathy on the part of minority shareholders could lead to their failure to participate in directors’ elections and consequently limit the practical relevance of enhanced-independence directors. In addition, it seems that the effectiveness of the Bebchuk and Hamdani proposal may also depend on the type of minority investors supporting the election of enhanced-independence directors. To be sure, a purely activist-driven approach initiated hedge funds may raise concerns regarding the effectiveness of the measure to have enhanced-independence directors act in the interest of all minority shareholders. Alternatives aimed at stimulating and favoring the involvement of institutional investors in the election of enhanced-independence directors should be developed.
I therefore argue in favor of enhancing the involvement of non-activist institutional investors. Based on an extensive comparative analysis, I show that the Italian system illustrates that the slate voting system, coupled with the coordination role performed by non-profit associations representing institutional investors, might foster greater involvement by institutional investors in the appointment, re-election, and termination of some enhanced-independence directors. Similarly, in the U.S., the Council of Institutional Investors might perform a coordination role in order to promote the participation of institutional investors in director elections and the appointment of minority-supported candidates.
In addition, considered the basic distinction between independence in appearance and independence in mind, in order to induce independent directors to perform their oversight function in a truly independent way, the formal approach to independence currently adopted internationally should be replaced with a more effective regulatory strategy aimed at providing directors with incentives to stimulate their independent conduct. Obviously, in order to turn independent directors into enhanced-independence directors by reducing controlling shareholders’ influence over them, it is necessary to prevent possible distorting incentives resulting from personal and business ties to the controlling shareholders. However, enhancing the independence of directors at controlled companies requires closer consideration to be given to the “human nature” of corporate boards. Therefore, given that the social dimension of the board can impact directors’ conduct regardless of the firm’s ownership structure, incentives aimed at preventing the decisions of enhanced-independence directors from being distorted by behavioural biases—including groupthink—should be introduced. In particular, within a context of concentrated ownership, legislators should consider measures that promote unbiased decisions by independent directors concerning transactions that are influenced by controlling shareholders. First, a term limit for enhanced-independence directors is recommended, as a long tenure may intensify structural biases and social ties, which could also potentially affect the conduct of these directors. Second, enhanced-independence directors should be granted full access to relevant information concerning transactions with controlling shareholders. Third, a more extensive disclosure of the enhanced-independence directors’ opinion could be required in order to facilitate public scrutiny of their decisions. As such an increased disclosure exposes independent directors to a reputational risk where their decisions or opinions are perceived to be not sufficiently motivated or objective, independent directors’ reputational concerns are capable of ensuring that their positions are more aligned with those of appointing investors than with those of the management, thereby increasing the quality of monitoring.
Giovanni Strampelli is Associate Professor of Commercial Law at Bocconi University.