Independence at a price
February 9, 2007
What does the demand to appoint independent non-executive directors mean in practice?
In public companies, non-executive directors are intended to prevent a concentration of power with the chief executive officer and/or senior executive directors of the firm. To act as an effective counterweight to the executive membership of a board, non-executive directors are presumed to be independent from the firm. But, how is this independence achieved in practice?
Following a string of financial scandals including those of Enron and WorldCom, Derek Higgs was commissioned by the UK government to review the role and effectiveness of non-executive directors. Higgs’ report, which served as the basis for the Combined Code on Corporate Governace proposed that nomination committees should ‘consider candidates from a wide range of backgrounds and look beyond the “usual suspects”’.
The implicit assumption here is that if non-execs come from outside the social networks of the existing directors, it is more likely that they would be independent. Unsurprisingly, numerous services sprung up, offering to match potential NEDs with companies looking to satisfy the regulatory demands (for example).
But, what does the demand to ‘diversify the boards’ really do to nomination practices? The Combined Code asks the firms to appoint non-executive directors from backgrounds that are different from those from which non-execs usually came. Diversity, in effect, is understood and practiced as social distance: the more remote a candidate is from the firm, the more independent she or he are deemed to be.
Of course, social distance comes at a price. The more distant one is from a social realm, the less one would know about it. This introduces an inevitable trade-off the firms. The more knowledgeable the NED they appoint would be, the more likely it is that she or he would be seen as ‘too close’ and would not be recognized by the Code as independent. Conversely, appointing a person who is remote from the firm’s realm of activity may result in the appointment of someone who is virtually clueless about the nature of the business.
The result is that the current regulatory demands turn the recruitment of non-executive directors into a utility-maximization (or damage-minimization) exercise. Firms are asked, in practice, to find the ideal candidate, one who would be stranger enough to the firm to be regarded as independent, but not too ignorant about the commercial activity to stifle the operation of the board.