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12.3: Director Independence

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    New stock exchange listing requirements stipulate that the majority of directors of public companies be “independent.”An exception is made for “controlled companies”—those for which more than 50% of the voting power is held by an individual, a group, or other company. The rules further state, “No director will qualify as independent unless the board affirmatively determines that the director has no material relationship with the listed company” and require companies to disclose determinations of independence in its annual proxy statement or, if the company does not file an annual proxy statement, in the company’s annual report on Form 10-K filed with the SEC.

    The rationale for increasing independence was that shareholders, by virtue of their inability to directly monitor management behavior, rely on the board of directors to perform critical monitoring activities and that the board’s monitoring potential is reduced, or perhaps eliminated, when management itself effectively controls the actions of the board. Additionally, outside directors may lack independence through various affiliations with the company and may be inclined to support management’s decisions in hopes of retaining their relationship with the firm. Requiring a board to have a majority of independent directors therefore increases the quality of board oversight and lessens the possibility of damaging conflicts of interest.