The Independent Director (Part 1): How Boards are at Risk
In this article, I examine some of the principles underlying the concept of independent directors and list four types of situations that can bring into question the role of individual board members and the decisions of a board of directors. In the next issue of this newsletter, I will examine each of these situations and suggest ways to enhance the potential for independence.
The ability of directors to make independent decisions is an issue of growing concern in both the nonprofit and corporate sectors. In the field of corporate governance, this concern takes the form of an obsession with counting independent directors (e.g., directors who are not employed by the corporation) and examining the role they play in preventing conflicts of interest. Is it most important that they be on the audit committee, the nominating committee, the compensation committee? Less attention has been paid, however, to the criteria used to classify directors as independent. The list of "independent" directors of some companies includes directors who are immediate relatives and current suppliers. They are able to get away with this because there is no legal definition to enforce a common standard.
Other current areas of inquiry by academics include whether the number of independent directors has any relationship to company performance and to what extent independent directors protect the company from wrong-doing. One recent report from York University suggests that processes to involve independent directors appropriately are more important than percentages or absolute numbers.
The Duty of Loyalty, confirmed in common law and many guides to good governance, requires that all directors act with honesty and in good faith in what they reasonably believe to be the best interests of the organization. While it seems the regulators and the public would be satisfied to see some truly independent directors on corporate boards and on certain committees, people sometimes question the integrity of nonprofit organizations unless all directors are perceived as fully able to make fair decisions in the best interest of the organization. The nonprofit sector, as usual, is being held to a higher standard. This is proper, but there is a risk that our sector's higher standards could be lowered and made less appropriate through application of Sarbanes-Oxley or other corporate governance thinking without sector-appropriate definitions or standards.
Principles and Premise
What principles are at stake? The main one, common to both sectors, is the need for directors to make fair and impartial decisions on behalf of the organization. Society does not perceive the decision-making as fair if the director's vote is influenced by issues such as household income or the need to stay on good terms with the boss. Nor is any potential director encouraged by the sight of "trained seal" directors voting to support the recommendation of a friend or superior.
This article is not about the legality of who is on the board or what situations are legally unacceptable. In some jurisdictions, laws limit or prevent certain types of board appointments, such as staff members, and prohibit direct financial benefits without prior government approval. I am not aware of any law requiring nonprofit boards to have any directors who ARE dependent. My premise is that governance is more likely to be effective and ethical if every board member can make all or most board decisions as an independent. That means only short-term decisions, with no lingering involvement, could be ethically resolved by a conflict of interest (COI) declaration (provided the situation itself is legal) and compliance with COI policies. The COI process, no matter how good, is inadequate in my opinion for long-term situations, particularly those involving primary responsibilities of the board.
Constraints on Independence
What could keep a director from being independent? Here are some examples
- Receiving direct business income as a supplier to the organization (e.g., an owner, an employee or salesperson for a supplier; a partner in a law firm supplying services)
- Receiving indirect business benefit such as an expectation of reciprocal business, corporate board appointment or some other business-related favour
- Trying to market to the organization's clients or members
- Using inside knowledge gained at the board to start or expand a business by capitalizing on that non-public knowledge
- Having your superior on the board, so that discussion and voting are constrained by the presence of someone who controls your performance appraisal, pay and promotion
- Being an employee of the organization and thus at risk if strategic directions for the organization are inconsistent with continued need for your position
- Being a senior staff member of another organization where the senior staff officer of this organization is on your board and your compensation committee (common in the corporate world)
- Being interested in an upcoming staff position at the organization
Family and Personal Interests
- Having a family member on staff or as a supplier, affecting household income in some cases and perceived ties of affection in all cases
- Having a family member on the board, where dissenting opinions can cause family arguments, family arguments can interfere with the Board's decision-making and some family members will not be comfortable speaking up at all in the presence of a more dominant member of the family
- Using the board position to get extra benefits not available to other members of the organization, such as a director who is also a client trying to jump to the head of a waiting list
- Unthinking, unquestioning devotion to a founder or long-time leader at the organization
- Putting another organization first when making decisions at this board, perhaps the organization which elected or appointed the person to the board
- Continuing to sit on related boards whose missions have started to diverge and perhaps even conflict (made worse if perceived a public spokesperson for one or both)
Sometimes these situations are minor enough to be acceptable to stakeholders, at least until a crisis erupts. But when trouble arises, what was being quietly ignored can look quite unethical.
In part two of this article, I will examine each of these situations and suggest ways to enhance the potential for independence.