In the movie, The Fugitive (1993), the hard-bitten Senior Deputy U.S. Marshal Sam Gerard (Tommy Lee Jones) ordered his subordinates not to say, “hinky”: “I don’t want you guys using words around me that got no meaning!”
In The Princess Bride (1987), Vizzini’s (Wallace Shawn’s) inappropriate interjections of “Inconceivable!”, finally led Inigo Montoya (Mandy Patinkin) to observe, “You keep using that word. I do not think it means what you think it means.”
But in the governance context, it’s neither humorous nor meme-worthy for a word both common and crucial—like “independent”—to have several legitimate but possibly-conflicting definitions.
After corporate meltdowns such as those of Enron and WorldCom, but even before the passage of the Sarbanes-Oxley Act of 2002, the SEC’s Commissioner Harvey Pitt proposed that the NYSE and NASDAQ revise their “listing requirements” for the trading of shares in publicly-held corporations.
Both exchanges now insist that a majority of a company’s board, and all of the members of its audit and compensation committees, qualify as independent; and both obligate the board to determine whether individual directors are independent.
Yet independence is deceptively simple-sounding concept.
First, in its most colloquial (and loosest) meaning, an “independent director” of a corporation is a synonym for an “outside director”: that is, someone who does not also serve that company as an officer.
At least in theory, such a director would be more likely than an “inside director” not only to bring to the boardroom a perspective separate from management’s, but also (because she would not be jeopardizing her employment with the company) to raise questions or arguments, or to dissent, in directorial discussions.
A second, and multi-faceted, test for independence is imposed by the NYSE and NASDAQ themselves. An outside director is not considered independent if she, directly or through persons or companies with which she is affiliated, can be said to have a “material relationship” with the company—whether “commercial, industrial, banking, consulting, legal, accounting, charitable, [or] familial”—under NYSE Listed Company Manual §303A.02(a)(i), and its official Commentary, respectively. The first line of that section (which is titled, “Independence Tests”) announces that the section is designed “to tighten the definition of ‘independent director’ for purposes of these standards.”
Similarly, NASDAQ Listing Rule 5605 broadly disqualifies anyone “having a relationship which, in the opinion of the Company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.”
Both exchanges exclude from the category of a company’s independent directors anyone employed by the company during the last three years; and anyone who is a close family member of, or (except for domestic employees) lives in the home of, anyone who was employed by the company as a senior officer at any time during the previous three years.
Also considered non-independent are, under some circumstances, people whose family members have been employed by the company or its auditors; and people who (or who have relatives who) are employed by, or have a partnership or controlling interest in, the company’s major trading partners.
Under a third and still more restrictive definition, outside directors who meet these standards might not be seen as independent (technically, as “disinterested”) with regard to specific corporate activities from which they, or someone close to them, stand to benefit—either (a) directly as; (b) as a manager of; or (c) as a holder of a significant ownership interest in, the other party to the “self-dealing” transaction.
Such transactions are known as “related party” transactions under the SEC’s Regulation S-K, and as “director’s conflicting interest transactions” in Section 8.60 of the ABA’s Model Business Corporation Act, but have no specific name in Section 144 of the Delaware General Corporation Law.
NYSE Manual Section 303A.10 and NASDAQ’s analogous Rule 5610 require listing companies to, in the words of the former, “adopt and disclose a code of business conduct and ethics for directors, officers and employees” that should set out procedures for identifying, disclosing, and determining whether and how to engage in particular transactions of this type.
On a fourth and final level, even an outside director who satisfies the listing requirements of independence and is herself disinterested with regard to a specific transaction might not qualify as independent—with regard to board’s consideration of that transaction—if her connections to another director for whom the transaction does present such a personal conflict of interest could reasonably be seen as likely to compromise her own judgment.
The Supreme Court of Delaware has rejected the argument that “structural bias”—a general sense of solidarity among directors—automatically eliminates a director’s independence in determining the merits of allegations brought against a fellow member of her board. See, e.g., Beam v. Stewart, 845 A.2d 1040, 1050-1051 (Del. 2004), citing Aronson v. Lewis, 473 A.2d 805, 815 n.8 (Del. 1984).
But independence may well be forfeit when a director “is dominated by [an]other party, whether through close personal or familial relationship or through force of will,” or if she is “beholden to the allegedly controlling entity” for “a benefit, financial or otherwise, upon which [she] is so dependent or [that] is of such subjective material importance” to her that she might be considered biased. Orman v. Cullman, 794 A.2d 5, 25 n.50 (Del. Ch. 2007).
In some situations, the third (disinterestedness) and fourth (interpersonal independence) levels of this analysis may overlap: “Confusion over whether specific facts raise a question of interest or independence arises from the reality that similar factual circumstances may implicate both interest and independence, one but not the other, or neither.” Id. See also Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 362 (Del. 1993) (holding that “a director who receives a substantial benefit from supporting a transaction cannot be objectively viewed as disinterested or independent.”)
The Delaware Court of Chancery, addressing in a separate decision “the independence standards established by stock exchanges and the requirements of Delaware law,” noted that “a finding of independence (or its absence) under one source of authority is not determinative for purposes of the other,” although “the two sources of authority are mutually reinforcing and seek to advance similar goals.” In re EZCORP Consulting Agreement Derivative Litigation, 2016 WL 301245 (Del. Ch.), at *36.
And in 2003, after reflecting on “the recent reforms enacted by Congress and by the stock exchanges,” the Court acknowledged that “even the best minds have yet to devise across-the-board definitions that capture all the circumstances in which the independence of directors might reasonably be questioned. By taking into account all circumstances, the Delaware approach undoubtedly results in some level of indeterminacy, but with the compensating benefit that independence determinations are tailored to the precise situation at issue.” In re Oracle Corp. Derivative Litigation, 824 A.2d 917, 941 & n.62.
There’s certainly nothing hinky about that.
