European Business Organization Law Review 14: 401-424 401

2013 T.M.C.ASSER PRESS doi:10.1017/S1566752912001206

Independent Directors: After the Crisis

Wolf-Georg Ringe*

1. Introduction............................................................................................ 402
2. Independent directors and the financial crisis ........................................ 403
2.1 The regulatory and quasi-regulatory push ............................................. 405
2.2 A question mark behind independence .................................................. 407
3. Why do we have independent directors? ............................................... 408
3.1 Improving the boards performance ....................................................... 408
3.2 Criteria of independence ........................................................................ 410
4. Challenges to independence ................................................................... 412
4.1 Matching independence with industry and ownership structure ............ 413
4.2 Empirical evidence ................................................................................ 415
4.3 Incentive problems ................................................................................. 417
4.4 Substitutes for independence ................................................................. 418
5. Towards a functional understanding of board independence ................. 420
5.1 Improving independence ........................................................................ 420
5.2 Combining independence with dependence ........................................... 421
6. Conclusion ............................................................................................. 424

Abstract
This paper re-evaluates the corporate governance concept of board independence
against the disappointing experiences during the 2007-08 financial crisis. Inde-
pendent or outside directors had long been seen as an essential tool to improve the
monitoring role of the board. Yet the crisis revealed that they did not prevent firms
excessive risk taking; further, these directors sometimes showed serious deficits in
understanding the business they were supposed to control, and remained passive in
addressing structural problems.
A closer look reveals that under the surface of seemingly unanimous consensus
about board independence in Western jurisdictions, a surprising disharmony
prevails about the justification, extent and purpose of independence requirements.
These considerations lead me to question the benefits of the current system. Instead,
this paper proposes a new, functional concept of board independence. It would

* Professor of International Commercial Law, Copenhagen Business School; University of

Oxford. This contribution benefited from comments made by participants at the Conference of the
Nordic Company Law Scholars Network, held at Aarhus University in November 2012.
402 Wolf-Georg Ringe EBOR 14 (2013)

redefine independence to include those directors that are independent of the firms
controller, but, at the same time, it would require them to be more accountable to
(minority) shareholders.

Keywords: independent directors, corporate governance, minority protection,

financial crisis.

1. INTRODUCTION

A large proportion of directors should be independent. This was the overwhelm-

ingly backed consensus in Western economies during the past decades. Independent
or outside directors were seen as an essential tool to improve the monitoring role of
the board.1 These days, the ground is shifting. The 2007-08 global financial crisis
has highlighted serious shortcomings in the system. Independent directors have in
no way prevented firms excessive risk taking; further, they have sometimes shown
serious deficits in understanding the business they were supposed to control, and
have remained very passive in addressing structural problems in short, it is clear
now that there were severe shortcomings and that boards can have too much
independence.2 A closer look reveals that under the surface of seemingly unani-
mous consensus about independence in Western jurisdictions, a surprising dishar-
mony prevails about the justification, extent and purpose of independence
requirements. This prompts us to re-evaluate the entire concept. This paper explores
the idea of independence for company directors across Western jurisdictions. By
exploring the weaknesses of the concept over the past decades and recent insights
which came to light during the global financial crisis, this contribution proposes a
functional concept of board independence. This would include directors that are
independent of the firms controller but at the same time more accountable to
(minority) shareholders.
The paper is structured as follows. Section 2 discusses the role of independent
directors in the financial crisis and reviews current commentary and regulatory
initiatives. Sections 3 and 4 go one step back to the roots by exploring the justifica-
tion for independence across jurisdictions and raising four challenges to the sound-

1 In this contribution we speak of the board, largely for simplicity reasons knowing that

some countries use a two-tier board system. In these two-tier jurisdictions, we would refer to the
supervisory board.
2 See recent empirical contributions, for example, R. Adams, Governance and the Financial

Crisis, 12 International Review of Finance (2012) p. 7; A. Beltratti and R. Stulz, The Credit
Crisis Around the Globe: Why Did Some Banks Perform Better?, 105 Journal of Financial
Economics (2012) p. 1; D. Erkens, M. Hung and P. Matos, Corporate Governance in the 2007-
2008 Financial Crisis: Evidence from Financial Institutions Worldwide, 18 Journal of Corporate
Finance (2012) p. 389.
Independent Directors After the Crisis 403

ness of the instrument. Section 5 presents a proposal to move closer to a functional

concept of independence, both to make independence more operational and to
mitigate the problems and challenges presented earlier. Section 6 concludes.

2. INDEPENDENT DIRECTORS AND THE FINANCIAL CRISIS

The concept of board independence has originated in the United States. US case
law has long encouraged independent and non-employee directors, while US ex-
change rules require that company boards include a majority of independent direc-
tors and that key committees be composed of a majority, or entirely, of independent
directors.
Regulation is often scandal-driven or responds to economic crises. In response
to a number of major corporate and accounting scandals, including those affecting
Enron and WorldCom, the Sarbanes-Oxley Act reformed large parts of US corpo-
rate law and capital market regulation. This included a strengthening of board
independence: inter alia, the Sarbanes-Oxley Act required publicly traded compa-
nies to have wholly independent audit committees with the power and the duty to
select outside auditors.3
In a similar way, the global financial crisis of 2007-08 re-opened the debate
around corporate governance and risk management.4 Again, independent directors
were partly blamed for the major failures of checks and balances.5 The account that
the financial crisis was, if not caused, at least facilitated by idiosyncratic and institu-
tional deficits in board-level corporate governance has become ever more popular in
the financial press.6 But also, a number of academic papers seek to confirm the
account that boards not only failed, but failed in a way that contributed to or exacer-

3 E.M. Fogel and A.M. Geier, Strangers in the House: Rethinking Sarbanes-Oxley and the

Independent Board of Directors, 32 Delaware Journal of Corporate Law (2007) p. 33; K.J.
Hopt, Comparative Corporate Governance: The State of the Art and International Regulation,
59 American Journal of Comparative Law (2011) p. 1, at p. 25.
4 Numerous publications on this subject have already been published. See, for example,

S. Bainbridge, Corporate Governance After the Financial Crisis (Oxford, OUP 2012); C. Mayer,
Firm Commitment: Why the Corporation Is Failing Us and How to Restore Trust in It (Oxford,
OUP 2013); OECD, Corporate Governance and the Financial Crisis: Key Findings and Main
Messages (June 2009).
5 The iconic American investor Carl Icahn claims that the financial crisis was caused by the

failure of a significant set of checks and balances ultimately ending with the boards of directors.
See C. Icahn, Corporate Boards That Do Their Job, Washington Post, 16 February 2009, A 15.
6 J. Schnatter, Where Were the Boards? Accountability Shouldnt End with the CEO, The

Wall Street Journal 25 October 2008, A 11; D. Goldman, Goodbye and Good Riddance AIG
Directors!, cnnmoney.com, 30 June 2009, available at: <http://money.cnn.com/2009/06/30/news/
companies/aig_shareholder_meeting/index.htm>; J.R. Finlay, Outrage of the Week: Leadership
Fiddles While Bear Stearns Burns (blog entry, 14 March 2008), available at: <http://finlayon
governance.com/?p=423>.
404 Wolf-Georg Ringe EBOR 14 (2013)

bated the financial crisis and the resulting losses at banks and in the real economy.7
Most frequently, this line of scholarship suggests that boards of banks failed to
conduct proper risk oversight at their institutions in the years leading up to the finan-
cial crisis.8 Similarly, other scholars have noted that boards made poor decisions with
respect to compensation, operations and investment at financial institutions.9 In sum,
these accounts view the financial crisis and poor bank performance as a function of
corporate governance failure, particularly of monitoring boards.10
As might be expected, this stream of the literature has led to deeper critiques of
board performance, particularly the performance of independent directors. For
those who think that independent directors are of questionable value anyhow, this
may provide confirmation. But those who believe independent directors can play a
significant role in the management of general firm performance have sought to
rehabilitate these directors by pointing to their remediable deficits. According to
them, directors failed, for example, at risk management because they lacked appro-
priate incentives, expertise or information.11 Alternatively, they did not have the
power, tools or advisers to properly supervise and assess risk. As for any bad
decisions, again this was largely due to informational failures and asymmetries,
failed incentives or other fixable deficits at director level.12 Often, these critiques
revert to the argument that had boards been even more independent of management
they might have been more questioning of executives and successful in both their
monitoring role and depending on the legal system their managerial role.13

7 Boards of directors in general are said to have played an abysmal role. See L.L. Dallas,

Short-Termism, the Financial Crisis, and Corporate Governance, 37 Journal of Corporation

Law (2012) p. 265, at p. 352.
8 See M.E. Murphy, Assuring Responsible Risk Management in Banking: The Corporate

Governance Dimension, 36 Delaware Journal of Corporate Law (2011) p. 121.

9 See, e.g., J.C. Coffee, Jr, What Went Wrong? An Initial Inquiry into the Causes of the 2008

Financial Crisis, 9 Journal of Corporate Law Studies (2009) p. 1; R. Sprague and A.J. Lyttle,
Shareholder Primacy and the Business Judgment Rule: Arguments for Expanded Corporate
Democracy, 16 Stanford Journal of Law, Business and Finance (2010) p. 1, at pp. 31-32.
10 The narrative finds mixed support in the available empirical evidence. See B.R. Cheffins,

Did Corporate Governance Fail During the 2008 Stock Market Meltdown? The Case of the
S&P 500, 65 Business Lawyer (2009) p. 1; see also R. Stulz and R. Fahlenbrach, Bank CEO
Incentives and the Credit Crisis, 99 Journal of Financial Economics (2011) p. 11.
11 E.J. Pan, Rethinking the Boards Duty to Monitor: A Critical Assessment of the Delaware

Doctrine, 38 Florida State University Law Review (2011) p. 209, at pp. 225-231;
L.A. Cunningham, Rediscovering Board Expertise: Legal Implications of the Empirical Litera-
ture, 77 Cincinnati Law Review (2008) p. 465; R.M. Jones and M. Welsh, Toward a Public
Enforcement Model for Directors Duty of Oversight, 45 Vanderbilt Journal of Transnational
Law (2012) p. 343.
12 See N.F. Sharpe, Rethinking Board Function in the Wake of the 2008 Financial Crisis, 5

Journal of Business and Technology Law (2010) p. 99, at p. 110; see also L.A. Bebchuk and
H. Spamann, Regulating Bankers Pay, 98 Georgetown Law Journal (2010) p. 247.
13 See, e.g., J. Manns, Building Better Bailouts: The Case for a Long-Term Investment Ap-

proach, 63 Florida Law Review (2011) p. 1349, at p. 1392.

Independent Directors After the Crisis 405

The solution these accounts arrive at is to enhance the influence of independent

directors and to strengthen their independence and accountability in short, a
more of the same, just better. Thus, academics have proposed that legal standards
be revised to push independent directors to further supervise the risk management
of the company 14 and to have some level of expertise in such matters.15 Legal
.

liability standards are to be enhanced to similarly push boards to conduct prudent

oversight.16 Other accounts have argued for greater regulatory intervention to erect
structures in order to ameliorate observed behavioural deficits of boards and direc-
tors.17

2.1 The regulatory and quasi-regulatory push

Similar arguments have largely driven corporate governance regulatory responses

(and preludes to them) since the crisis. A good illustration is the so-called Walker
Report, carried out by Sir David Walker in 2009 to examine corporate governance
in the banking industry after the crisis.18 His report is almost entirely focused on
board failures and board-related remedies. The most relevant passage reads:

The most critical need is for an environment in which effective challenge of the
executive is expected and achieved in the boardroom before decisions are taken
on major risk and strategic issues. For this to be achieved will require close at-
tention to board composition to ensure the right mix of both financial industry
capability and critical perspective from high-level experience in other major
business. It will also require a materially increased time commitment from non-
executive directors (NEDs), from whom a combination of financial industry ex-
perience and independence of mind will be much more relevant than a combina-
tion of lesser experience and formal independence. In all of this, the role of the
chairman is paramount, calling for both exceptional board leadership skills and
ability to get confidently and competently to grips with major strategic issues.
With so substantial an expectation and obligation, the chairmans role will in-
volve a priority of commitment that will leave little time for other business ac-
tivity.19

14Pan, supra n. 11, at pp. 225-231.

15Cunningham, supra n. 11.
16 Jones and Welsh, supra n. 11.
17 K.N. Johnson, Addressing Gaps in the Dodd-Frank Act: Directors Risk Management

Oversight Obligations, 45 University of Michigan Journal of Law Reform (2011) p. 55, at p. 66.
These board-centred responses form the lions share of reform proposals outside the realm of
enhanced prudential regulation.
18 Sir David Walker, A Review of Corporate Governance in UK Banks and Other Financial

Industry Entities (2009), available at: <http://www.hm-treasury.gov.uk/d/walker_review_ consul-

tation_160709.pdf>.
19 Ibid., at p. 9.
406 Wolf-Georg Ringe EBOR 14 (2013)

The Walker Report thus focuses on fundamental aspects of board composition,

leadership and commitment. Beyond these structural aspects, it subsequently points
to the need for increased board oversight of risk management 20 and compensation
.

practices,21 as well as board engagement with long-term shareholders.22

Other examples are more concerned with bank governance and the specific
problems of financial institutions. For example, the Basel Committee on Banking
Supervision of the Bank for International Settlements recommended, in its 2010
Principles for Enhancing Corporate Governance, that banks should have a formal
written policy for dealing with conflicts of interests of board members as well as an
objective compliance process for implementing this policy.23 In a similar vein, the
European Commissions 2010 Green Paper on Corporate Governance in Financial
Institutions emphasised the importance of board independence and called for
improving recruitment practices and strengthening measures intended to prevent
conflicts of interests within the board and within the financial institution in gen-
eral.24 The Commission picked up this topic one year later in its second Green
Paper, dealing with corporate governance in general, in particular in the context of
remuneration policies.25 The Swiss Financial Market Supervisory Authority went as
far as to suggest that banks should have at least one third independent board mem-
bers.26
US regulation in the wake of the global financial crisis has also followed the
trend towards emphasising the role of the board and bolstering independence.27 For
example, the Dodd-Frank Act provides for the creation of risk committees to ensure
proper management of risk at financial and non-financial firms; these must be
comprised of independent directors and must include at least one expert in risk

20 Ibid., at pp. 78-89.

21 Ibid., at pp. 90-106.
22 Ibid., at pp. 60-77.
23 Basel Committee on Banking Supervision, Principles for Enhancing Corporate Govern-

ance (2010), paras. 55-56, available at: <http://www.bis.org/publ/bcbs176.pdf>.

24 European Commission, Green Paper: Corporate Governance in Financial Institutions and

Remuneration Policies (COM (2010) 284), at p. 11, available at: <http://ec.europa.eu/internal_

market/company/docs/modern/com2010_284_en.pdf>.
25 European Commission, Green Paper: The EU Corporate Governance Framework (COM

(2011) 164), at pp. 5, 9 and 14, available at: <http://ec.europa.eu/internal_market/company/docs/

modern/com2011-164_en.pdf>. See also on this the recommendations of the European Corporate
Governance Forum, Statement of the European Corporate Governance Forum on Director
Remuneration of 23 March 2009, in particular para. 6, available at: <http://ec.europa.eu/internal_
market/company/docs/ecgforum/ecgf-remuneration_en.pdf>.
26 Swiss Financial Market Supervisory Authority (FINMA), Board of Directors of Banks and

Securities Dealers (28 August 2012), at p. 2, available at: <http://www.finma.ch/e/faq/ beaufsi-

chtigte/ Documents/faq-oberleitung-banken-effektenhaendler-e.pdf>.
27 L. Fairfax, The Uneasy Case for the Inside Director, 96 Iowa Law Review (2010) p. 127,

at p. 136.
Independent Directors After the Crisis 407

management.28 It further requires compensation committee members to be fully

independent.29 The post-financial crisis board-related reform will not be detailed
here, but note that board-centred reform enhancing the power of inside directors has
become a commonly used regulatory technique in the US by lawmakers, regulators
and the stock exchanges.30 This trend has simply continued in post-crisis criticisms
and reforms. The net result is that directors, and particularly independent directors,
have emerged as a potentially more powerful and autonomous monitoring organ in
post-financial crisis corporate governance.31

2.2 A question mark behind independence

There are only few who question the entire concept of independence. Some observ-
ers, however, acknowledge that in some instances the question of independent
directors might have been pushed too far.32 OECD research suggests that inde-
pendence has mainly been implemented by setting up negative lists of undesirable
criteria and that this might have led to qualifications (i.e., a positive list) or suit-
ability being only of secondary importance.33 To this end, the OECD recommends
that such a negative list should usefully be complemented by positive examples of
director qualities that would increase independence.34 Moreover, they note that the
issue is not just independence and objectivity but also capabilities.35 Other re-
searchers emphasise that regulation itself has possibly contributed to the failure of
independent directors.36 That is, independence criteria in regulation often exclude
those very people that used to work at the firm, thus excluding key experts on the
subject matter of the firms business.37 In this vein, empirical studies that predomi-
nantly focus on the special case of banks have suggested that board independence is

28 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-203, H.R.

4173, 165.
29 Ibid., 952.
30 See, e.g., Sarbanes-Oxley Act of 2002, Pub.L. No. 107-204, 116 Stat. 745, 301 (requiring

audit committees comprised of independent directors); Dodd-Frank Act, supra n. 28, 165(h)
(requiring certain public financial companies and bank holding companies to have risk commit-
tees comprised of independent directors).
31 See P. Rose, Regulating Risk by Strengthening Corporate Governance, 17 Connecticut

Insurance Law Journal (2010) p. 1.

32 G. Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis, 96 OECD

Journal: Financial Market Trends (2009) p. 61, at pp. 81-82.

33 Ibid.
34 Ibid. See already OECD Principles of Corporate Governance (2004), at p. 64, available at:

<http://www.oecd.org/corporate/ca/corporategovernanceprinciples/31557724.pdf>.
35 Ibid.
36 J. Winter, The Financial Crisis: Does Good Corporate Governance Matter and How to

Achieve it?, in E. Wymeersch, K.J. Hopt and G. Ferrarini, Financial Regulation and Supervi-
sion: A Post-Crisis Analysis (Oxford, OUP 2012) p. 368, at p. 376, at 12.15.
37 Winter, ibid.
408 Wolf-Georg Ringe EBOR 14 (2013)

positively related to bank bailouts.38 The reason for increasingly independent boards
of banks could well be due to country-specific regulation.39
However, the overwhelming and uncritical support for independence is by no
means a global standard. Consider the example of Japan, where until recently no
independence at all was required for board members. In the wake of the accounting
scandal at Olympus, the Japanese optics and imaging company, the government
planned to require firms to appoint at least one independent director.40 However, for
conservative business circles, even this minimum step was too much; in the end,
legislation could only be passed in a version which had been watered down signifi-
cantly in favour of a mere comply-or-explain approach.41
In what follows, this question mark behind independence will be developed fur-
ther. The next section explores the roots of board independence, after which four
fundamental challenges to the concept are discussed. This then leads us to our more
functional account of board independence, overcoming the ostensible weaknesses.

3. WHY DO WE HAVE INDEPENDENT DIRECTORS?

In order to understand the conclusions we can draw from the crisis, we need to go
back to the roots of the concept of directors independence. In order to establish
whether anything has failed or should be modified, we need to understand why
independence was seen as desirable in the first place.

3.1 Improving the boards performance

Traditionally, the principle of director independence has been justified by the

proper role of boards: to provide effective and unbiased monitoring. As one of the
key roles of the board is to monitor the executive management, this task can be
carried out best if those who monitor are independent of those who are supervised.
At the root, therefore, is a conflict of interest dimension: independence is seen as a
coarse pre-condition for ensuring ex ante that board decisions are not tainted by
arbitrary considerations.42

38 R. Adams, Governance and the Financial Crisis, 12 International Review of Finance

(2012) p. 7; B. Minton, J. Taillard and R. Williamson, Financial Expertise of the Board, Risk
Taking and Performance: Evidence from Bank Holding Companies, Journal of Financial and
Quantitative Analysis (forthcoming 2013).
39 D. Ferreira, T. Kirchmaier and D. Metzger, Boards of Banks, ECGI Finance Working

Paper No. 289/2010, available at: <http://ssrn.com/abstract=1620551>.

40 Olympian Depths, The Economist, 3 November 2012, p. 12.
41 Back to the Drawing Board, The Economist, 3 November 2012, p. 68.
42 See on this, R. Nolan, The Legal Control of Directors Conflicts of Interest in the United

Kingdom: Non-Executive Directors Following the Higgs Report, in J. Armour and J. McCahery,
eds., After Enron: Improving Corporate Law and Modernising Securities Regulation in Europe
and the US (Oxford, Hart Publishing 2006) p. 367.
Independent Directors After the Crisis 409

This rationale is confirmed by the fact that the importance of independence has
been emphasised in particular areas within the board where such conflicts of inter-
ests are potentially most salient. In this sense, most regulatory initiatives over the
past decades that have refined the concept put special emphasis on independence
for board committees, such as the remuneration committee, the nomination commit-
tee and the audit committee. In these fields, potential conflicts are exacerbated: for
example, the audit committee is the key body evaluating the performance of the
management. Here, the temptation will be great to let personal connections prevail
over objective criteria. To this end, most regulators worldwide establish reinforced
independence criteria for these or similar committees.
Our initial sense of policy is supported by a brief survey of justifications usually
cited. For example, the requirements of the New York Stock Exchange state that
[r]equiring a majority of independent directors will increase the quality of board
oversight and lessen the possibility of damaging conflicts of interest.43
Academic scholarship has refined the theoretical underpinnings for independence
in various ways. One of the classic academic articles dealing with the problem em-
phasises that independent directors act as shareholder surrogates to assure that the
company is run in the long-term best interests of its owners. This quote incidentally
sounds as if it is part of the current debate around short-termism in company law;
yet it comes from a 1991 article by Ronald J. Gilson and Reinier Kraakman.44 The
important implication (and extension to the basic monitoring role) is that independ-
ence ultimately has the goal of furthering the interests of the shareholders, and that it
is not an end in itself.45 From this perspective, independent directors are seen as a
trustee for shareholders, to mitigate managerial agency costs.46
But independent directors have been considered as a tool with much wider ob-
jectives; one may even say as a panacea to mitigate almost every problem of com-
pany law. Thus, independent directors are said to prevent self-dealing by examining
conflict of interest transactions; they should monitor management to detect and
prevent managerial fraud; further, independent directors are supposed to examine
corporate affairs and thus to prevent managerial mismanagement. Some even go as
far as to say that independent directors serve the interests not just of the sharehold-
ers, but of all stakeholders, if not of society as a whole.47

43 NYSE Listed Company Manual, 303 A.01, available at: <http://nysemanual.nyse.com/lcm>.

44 R.J. Gilson and R. Kraakman, Reinventing the Outside Director: An Agenda for Institu-
tional Investors, 43 Stanford Law Review (1991) p. 863, at p. 873.
45 Gilson and Kraakman note, however, that this statement still does not explain how inde-

pendent directors effectively carry out their role. See ibid., at pp. 873-874.
46 L. Enriques, H. Hansmann and R. Kraakman, The Basic Governance Structure: The Inter-

ests of Shareholders as a Class, in R. Kraakman, et al., The Anatomy of Corporate Law, 2nd edn.
(Oxford, OUP 2009) p. 64 (trusteeship strategy).
47 On this discussion, see P. Beleya, et al., Independent Directors and Stakeholders Protec-

tion: A Case of Sime Darby, 2 International Journal of Academic Research in Business and
Social Sciences (2012) p. 422.
410 Wolf-Georg Ringe EBOR 14 (2013)

Jeffrey Gordon, in a 2007 article, advanced the idea of a connection between the
role of independent directors and the development of the stock market, in particular
addressing the problem of directors who are less informed and familiar with the
company.48 His argument is that increasingly sophisticated and efficient stock
markets permit companies to retain more independent directors, since the more
informative share price serves as a signal for them and makes up for the lack of
business understanding.49 Thus, Gordon argues, independent directors are more
valuable than insiders since they are less captured by the management. The more
developed and informed the stock market is, the easier it is for independent direc-
tors to monitor the management and, consequently, the more functional it is to have
independent directors on the board, avoiding reliance on explicit expertise.

3.2 Criteria of independence

These theoretical accounts give a comprehensive picture and provide ample justifi-
cation for having independent directors on the board. Yet it is surprisingly unclear
what the precise criteria are for determining whether a director is truly independ-
ent.50
Some regulators try to define independence by providing an abstract, general
description. This strategy has predominantly been used by international bodies that
try to combine approaches applicable across jurisdictions. Thus, for example, the
Basel Committee finds that the key characteristic of independence is the ability to
exercise objective, independent judgment after fair consideration of all relevant
information and views without undue influence from executives or from inappro-
priate external parties or interests.51
At the national level, many regulatory instruments give a list of criteria which
attempt to describe what does not constitute independence. For example, both the
UK Corporate Governance Code 52 and the NYSE Listed Company Manual 53 pro-
. .

vide a relatively similar negative catalogue of criteria that would normally exclude
a specific directors independence, such as where the director

48 J. Gordon, The Rise of Independent Directors in the United States, 1950-2005: Of Share-

holder Value and Stock Market Prices, 59 Stanford Law Review (2007) p. 1465.
49 Ibid., at pp. 1541-1563. See, for criticism, Bainbridge, supra n. 4, at pp. 99-100.
50 For a recent overview, see P. Davies and K.J. Hopt, Corporate Boards in Europe Ac-

countability and Convergence, 61 American Journal of Comparative Law (2013) p. 301, at pp.
317-326; M. Roth, Unabhngige Aufsichtsratsmitglieder, 175 Zeitschrift fr das gesamte
Handels- und Wirtschaftsrecht (ZHR) (2011) p. 605.
51 Basel Committee, supra n. 23, para. 38.
52 Financial Reporting Council, The UK Corporate Governance Code (September 2012),

B.1.1, available at: <http://frc.org.uk/Our-Work/Codes-Standards/Corporate-governance.aspx>.

53 NYSE, Listed Company Manual, supra n. 43, 303 A.02.
Independent Directors After the Crisis 411

has been an employee of the company or connected entity within the past years;
is or has been connected with the companys auditors, advisers, directors or
senior employees;
has received additional remuneration from the company apart from the direc-
tors remuneration;
has had a material business relationship with the company; or
represents a significant shareholder (UK only).

Some jurisdictions have gone further by increasing the level of detail and the
complexity of such lists, thus making them very complex to apply.54
An example of a compromise solution may be found in the German Corporate
Governance Code.55 The German Code provides a (short) list of criteria, but quali-
fies them in the following way: a director is not deemed independent if he/she has
personal or business relations with the company, its executive bodies, a controlling
shareholder or an enterprise associated with the latter which may cause a substan-
tial and not merely temporary conflict of interests [emphasis added].56 This ap-
pears to be a middle ground between the two extreme models described above: first
providing a list of substantial criteria which, however, only count if there is a
substantial, long-term conflict of interests.
The EU Recommendation of 2005 on this subject 57 almost resignedly states that
.

[i]t is not possible to list comprehensively all threats to directors independence;

the relationships or circumstances which may appear relevant to its determination
may vary to a certain extent across Member States and companies, and best prac-
tices in this respect may evolve over time. Nevertheless, the Recommendation then
goes on to give a very detailed list indeed.58
Do all of these differences matter? It is submitted that the regulatory style of
drafting the law is of less importance than the actual substantial differences. And,
indeed, substantial differences do exist. There is a surprising divergence as to the
relevance of independence from controlling shareholders: for example, this crite-
rion is included in the UK catalogue, but not in its US counterpart as listed above.59

54 See, for example, the Danish Corporate Governance Code, May 2013, section 3.2, avail-

able at: <http://corporategovernance.dk/english>. On board independence in Nordic company

law, see the excellent article by J. Lau Hansen, On the Independence of Directors in the Nordic
Countries Where the Shareholder Is King, in P. Krger Andersen, N. Jul Clausen and R. Skog,
eds., Shareholder Conflicts (Copenhagen, Thomson 2006) p. 69.
55 German Corporate Governance Code (2013 version), available at: <http://www.corporate-

governance-code.de/eng/kodex/index.html>.
56 Ibid., section 5.4.2.
57 European Commission, Recommendation of 15 February 2005 on the role of non-

executive or supervisory directors of listed companies and on the committees of the (supervisory)
board, OJ 2005 L 52/51.
58 Ibid., Annex II.
59 See, in more detail, Enriques, et al., supra n. 46, at p. 66, in particular footnote 60.
412 Wolf-Georg Ringe EBOR 14 (2013)

Germany introduced this criterion only recently, but will only consider it relevant if
it involves a substantial and long-term conflict of interests.60 Another area of diver-
gence is the situation of employee representatives on the board, where Germany
differs from most other legal systems, due to its system of co-determination.61 More
generally, the various instruments presented here do not just differ in regulatory
style or substance, but also, and fundamentally, in who ultimately determines if the
board members of a particular company fulfil the independence criteria or not.62 To
illustrate, the US approach is mandatory in the sense that the NYSE listing author-
ity will scrutinise their own criteria objectively. By contrast, many other jurisdic-
tions leave the final decision on what constitutes independence to the board itself.
This is the case not only under the EU Recommendation, but also in the UK, where
the board determines whether each director is independent in character and judg-
ment.63 The above-mentioned criteria are then only non-binding guidelines for the
board, which is free to deviate under the well-known comply or explain principle.
This approach ultimately leaves the question to the market to judge.
In summary, it appears that a closer look at the legal systems of Western
economies testifies to a large divergence in the understanding of independence of
board members. This is true for both the regulatory justification of the concept and
the precise criteria that are relevant for determining independence.

4. CHALLENGES TO INDEPENDENCE

The starting point for this paper has been the unequalled triumph of the concept of
director independence in Western corporate governance over the past decades.
Following this, we have seen that the notion of independence is ambiguous and is

60 The 2012 revision of the German Corporate Governance Code included the criterion of

personal or business relationship with a controlling shareholder in the list in section 5.4.2. See on
this in detail, T. Florstedt, Die Unabhngigkeit des Aufsichtsratsmitglieds vom kontrollierenden
Aktionr, Zeitschrift fr Wirtschaftsrecht (ZIP) (2013) p. 337. A first court case concerning
Thyssen Krupp AG is now pending at the courts, see D. Fockenbrock, Strengers Kampf fr
Unabhngigkeit, Handelsblatt, 22 February 2013, p. 22.
61 K.J. Hopt, Corporate Governance of Banks after the Financial Crisis, in Wymeersch,

Hopt and Ferrarini, eds., supra n. 36, p. 337, at p. 360, at 11.52.

62 K.J. Hopt, Comparative Corporate Governance: The State of the Art and International

Regulation, 59 American Journal of Comparative Law (2011) p. 1, at p. 36.

63 UK Corporate Governance Code, supra n. 52, section B.1.1: The board should identify in

the annual report each non-executive director it considers to be independent. The board should
determine whether the director is independent in character and judgement and whether there are
relationships or circumstances which are likely to affect, or could appear to affect, the directors
judgement. The board should state its reasons if it determines that a director is independent
notwithstanding the existence of relationships or circumstances which may appear relevant to its
determination, including.
Independent Directors After the Crisis 413

interpreted differently across countries. This section puts forward a number of

challenges to the concept and prepares the ground for a functional account of board
independence (see below, section 5).
Challenges to the concept of board independence include inherent weaknesses
of the concept and more recent empirical and doctrinal insights. Four challenges
may helpfully be distinguished: the fundamental problem of matching independ-
ence with industry and ownership structures; questionable empirical evidence of
the benefits of the concept; incentive problems; and substitutes in the legal system.
We will consider each of these points in turn.

4.1 Matching independence with industry and ownership structure

The review of different independence criteria undertaken above illustrates a

surprising arbitrariness of the relevant criteria and a high uncertainty as to whether
the chosen criteria are actually useful in a given context.
It would be oversimplifying the matter to require that all jurisdictions should de-
fine independence along the same lines. Quite the contrary, independence does and
should mean fundamentally different things depending on the shareholder structure
and industry structure in which it operates.64 This has already been recognised by
the OECD Principles of Corporate Governance, which state that [t]he variety of
board structures, ownership patterns and practices in different countries will thus
require different approaches to the issue of board objectivity.65 A functional per-
spective on board independence would thus attempt to match the precise definition
of independence of the particular jurisdiction to the particular needs that arise from
the concrete ownership structure.
To illustrate, consider the basic agency conflicts in corporate governance. As is
well-known, in concentrated ownership systems, the main intra-company conflict
lies between controlling shareholders and minority shareholders; and company law
has as its predominant objective to mitigate the costs resulting from this conflict.
Thus, independent directors need to be understood as one tool in the larger toolkit
for dealing with shareholder conflicts; it follows that independence from the con-
trolling shareholder is an essential criterion when determining whether a particular
person is independent.66 By contrast, in dispersed ownership structures, where
managerial agency costs tend to be high, this criterion is largely irrelevant, if not
counterproductive. To illustrate the implications of both scenarios in practice,
consider the following two examples. The recent extension of the German inde-

D. Johanson and K. stergren, The Movement Toward Independent Directors on Boards:

64

A Comparative Analysis of Sweden and the UK, 18 Corporate Governance: An International

Review (2010) p. 527; Davies and Hopt, supra n. 50, at pp. 323-324.
65 OECD Principles of Corporate Governance (2004), supra n. 34, section VI.E.
66 M. Gutirrez and M. Sez, Deconstructing Independent Directors, 13 Journal of Corpo-

rate Law Studies (2013) p. 63.

414 Wolf-Georg Ringe EBOR 14 (2013)

pendence definition to include independence from controlling shareholders was a

sensible step in the right direction, as German corporate structure is traditionally
dominated by strong blockholders.67 By contrast, the UK is famously known for its
dispersed shareholder ownership structure. Its insistence that independence within
the meaning of the UK Corporate Governance Code includes the absence of any
links with a significant shareholder must be surprising, to say the very least.68
In a similar way, different industry structures might call for different instru-
ments of corporate governance.69 For example, Gordons analysis linking director
independence to the information provided by the stock market may work well in
highly developed equity markets like the United States.70 To the extent that stock
markets are efficient, independent directors can rely on the signals received from
the share price. However, this implies, a contrario, that board independence in
jurisdictions with less developed stock markets should be careful when transposing
the same legal instrument into their domestic law. For example, in jurisdictions
where the corporate sector relies more on bank financing or workers skills, like
Japan and Germany, independent directors must necessarily perform a different
function.71
It is submitted that independence is frequently used without further reflection,
whereby sight is lost of these basic parameters. We will return to this issue below,
but for now, it is important to make the point that there is no universal definition of
independence. This follows from the distinct function that independence has to
perform in a given jurisdiction, depending on shareholder structure, industry struc-
ture and regulatory goals.72 Comparing the concept of independence in two coun-
tries therefore automatically comes down to comparing apples and oranges. This
conclusion has implications for any worldwide attempt to harmonise or even con-
ceptualise standards in instruments developed by the likes of the OECD, the Basel
Committee, and the European Union.73 If and where such international instruments

67 On this change, see H.M. Ringleb, et al., Die Kodex-nderungen vom Mai 2012, Neue

Zeitschrift fr Gesellschaftsrecht (NZG) (2012) p. 1081, at pp. 1087-1088.

68 UK Corporate Governance Code, supra n. 52, section B.1.1.
69 P.A. Hall and D. Soskice, eds., Varieties of Capitalism: The Institutional Foundations of

Comparative Advantage (Oxford, OUP 2001); W. Carlin and C. Mayer, Finance, Investment and
Growth, 69 Journal of Financial Economics (2003) p. 191; M. Blair and L. Stout, A Team
Production Theory of Corporate Law, 85 Virginia Law Review (1999) p. 247.
70 See supra n. 48 and accompanying text.
71 On data supporting these different factors for industry structures, see Carlin and Mayer,

supra n. 69, at pp. 204-208.

72 Johanson and stergren, supra n. 64, at p. 535, see merits in understanding independence

as a global principle of corporate governance. However, they insist that the practical meaning
differs across jurisdictions.
73 See, e.g., for a sceptical account of harmonisation attempts in corporate law L. Enriques,

EC Company Law Directives and Regulations: How Trivial Are They?, 27 University of
Pennsylvania Journal of International Economic Law (2006) p. 1.
Independent Directors After the Crisis 415

or guidelines nevertheless try to make recommendations for a multitude of jurisdic-

tions, they risk becoming so wide and generalised that the result is vague and of
little concrete value.74 An example is the OECD Code of Governance, which tries to
provide an internationally valid statement, yet cannot help being more descriptive
than helpful:

In many instances objectivity requires that a sufficient number of board mem-

bers not be employed by the company or its affiliates and not be closely related
to the company or its management through significant economic, family or other
ties. This does not prevent shareholders from being board members. In others,
independence from controlling shareholders or another controlling body will
need to be emphasised, in particular if the ex ante rights of minority sharehold-
ers are weak and opportunities to obtain redress are limited. This has led to both
codes and the law in some jurisdictions to call for some board members to be
independent of dominant shareholders, independence extending to not being
their representative or having close business ties with them. In other cases, par-
ties such as particular creditors can also exercise significant influence. Where
there is a party in a special position to influence the company, there should be
stringent tests to ensure the objective judgement of the board. 75

4.2 Empirical evidence

The second challenge to independence is the mixed empirical support it has re-
ceived in recent years. Essentially, scholars have tried to evaluate whether inde-
pendent directors improve firm performance, and have come up with overall mixed
results.76 As a consequence, there is uncertainty about the merits of the entire
concept of independence.
For example, in two ground-breaking studies, American scholars Bhagat and
Black come to the conclusion that the number of independent directors on the board
is negatively correlated with firm performance.77 A European study arrives at

74 An example is the discussion on the benefits of a possible EU-wide corporate governance

code. See Weil, Gotshal & Manges LLP, Comparative Study of Corporate Governance Codes
Relevant to the European Union and Its Member States: Final Report (2002), available at:
<http://ec.europa.eu/internal_market/company/docs/corpgov/corp-gov-codes-rpt-part1_en.pdf>
(and <part2_en.pdf>), at pp. 81-83.
75 OECD Principles of Corporate Governance (2004), supra n. 34, section VI.E.
76 For recent overviews, see L.A. Bebchuk and M.S. Weisbach, The State of Corporate Gov-

ernance Research, 23 Review of Financial Studies (2010) p. 939, at pp. 943-945; R. Adams, The
Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey, 48
Journal of Economic Literature (2010) p. 58, at pp. 80-86.
77 S. Bhagat and B. Black, The Uncertain Relationship Between Board Composition and

Firm Performance, 54 Business Lawyer (1999) p. 921; S. Bhagat and B. Black, The Non-
Correlation Between Board Independence and Long-Term Firm Performance, 27 Journal of
Corporation Law (2002) p. 232.
416 Wolf-Georg Ringe EBOR 14 (2013)

similar conclusions by measuring the impact of independent directors on compensa-

tion levels.78 A 2007 study analysing independent directors in British firms, how-
ever, is more optimistic about their impact on firm performance.79
More recent scholarly work looks at the performance of independent directors
during the financial crisis. Anecdotal evidence suggests that they did not perform
well during the crisis.80 Indeed, a recent expert report calls on the European Com-
mission to re-evaluate the concept of independent directors and identify whether
their role is satisfactory and whether independence criteria should not be revis-
ited.81 The Commission is currently consulting on further steps.82 Some go further
and say that independent directors were too independent to understand the com-
plexities of the businesses they nominally directed (i.e., too independent of the
company they were supposed to monitor)83 or that the concept of board independ-
ence might have been pushed too far.84 In short, [r]egulation may actually have
contributed to the lack of meaningful involvement of non-executive directors.85
Some recent work and policy initiatives have emphasised the lack of expertise
rather than sheer independence of directors as key to the problem.86 Pure independ-
ence without expertise about the companys business is surely unsuitable;87 put
differently, you could question the expertise of independent directors in general.
The latest empirical research on financial institutions shows that banks with more

78 N. Fernandes, EC: Board Compensation and Firm Performance: The Role of Independ-

ent Board Members, 18 Journal of Multinational Financial Management (2008) p. 30.

79 J. Dahya and J. McConnell, Board Composition, Corporate Performance, and the Cadbury

Committee Recommendation, 42 Journal of Financial and Quantitative Analysis (2007) p. 535.

80 Reflection Group on the Future of EU Company Law, Report of 5 April 2011, section

3.1.6: it can be noted that the role played by (independent) directors in the crisis period has
not necessarily been convincing and that sometimes even a certain level of distrust in independent
directors and their level of knowledge relevant to the company of which they are a director, can
be identified, available at: <http://ec.europa.eu/internal_market/company/docs/modern/reflection
group_report_en.pdf>.
81 Ibid., at pp. 50-51.
82 The Report was discussed at a public conference in Brussels on 16 and 17 May 2011. The

Commission then launched a public consultation to seek views from all stakeholders on European
company law from 2012 onwards. See Consultation on the Future of European Company Law,
at: <http://ec.europa.eu/internal_market/consultations/docs/2012/companylaw/questionnaire_en.
pdf>. The feedback statement is available at: <http://ec.europa.eu/internal_market/consultations/
docs/2012/companylaw/feedback_statement_en.pdf>. See also European Commission, Green
Paper: The EU Corporate Governance Framework, supra n. 25, section 2.7.2 and Q22.
83 D. Nordberg, Corporate Governance and the Board in S.O. Idowu and C. Louche, eds.,

Theory and Practice of Corporate Social Responsibility (Springer 2011) p. 39, at p. 51; see also
Lau Hansen, supra n. 54, at p. 79.
84 G. Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis, 96 OECD

Journal: Financial Market Trends (2009) p. 61, at pp. 81-82.

85 Winter, in Wymeersch, Hopt and Ferrarini, supra n. 36, at p. 376, at 12.15.
86 See, with further references, Davies and Hopt, supra n. 50, at pp. 322-323.
87 But see the arguments developed by Gordon, supra n. 48.
Independent Directors After the Crisis 417

independent board members who lacked financial expertise performed worst during
the crisis.88
These accounts all have far-reaching implications for the benefits associated
with board independence. Taken together, the empirical studies show that board
independence will at least not always be helpful in improving company perform-
ance. This raises the question of why regulators (and, indeed, companies them-
selves) continue adding ever more independence criteria. It is conceivable that
diminishing marginal returns mean that the optimal number of independent direc-
tors, at least for US companies, may already have been well exceeded.

4.3 Incentive problems

Another problem might be that independence in itself is not enough; scholars have
recently been focusing increasingly on the proper incentive structure for independ-
ent directors. This intuitively makes sense, given the numerous tasks we assign to
independent directors and the almost superhuman results we expect from them:
they are supposed to guard against self-dealing by examining conflict of interest
transactions; we expect them to actively oversee management and to detect and
prevent fraud; further, independent directors are supposed to examine corporate
affairs and thus prevent managerial mismanagement.89
In short: we ask a lot of them. In particular, we expect independent directors to
speak out and to take a proactive role in monitoring. What, other than possibly
reputational or moral constraints, can incentivise them to take up this challenge?
What, as some have described it, can encourage them to fight the battle rather
than enjoy an easy life by taking a laid-back approach to monitoring?90
Consider the recent Olympus scandal in Japan, mentioned above.91 Given the
scarcity of independent board members in Japan, Olympus stood out amongst
Japanese firms by actually having three independent members on its board. How-
ever, none of them intervened or prevented the management from misbehaving.
Opponents to more independence on Japanese boards use this as an argument to
support their claim that (the lack of.) independence was not the problem, nor will
increasing independence help solve the problem.92 Rather, it seems that the inde-
pendent directors did not dare speak out: former Olympus president Michael Wood-
ford described them as acting like children in a classroom when they were asked

88 Ferreira, Kirchmaier and Metzger, supra n. 39. See also H. Hau and M.P. Thum, Sub-

prime Crisis and Board (In-)Competence: Private versus Public Banks in Germany, 24 Economic
Policy (2009) p. 701.
89 See above section 3.
90 P.L. Davies and S. Worthington, Gower and Davies Principles of Modern Company Law,

9th edn. (London, Sweet & Maxwell 2012), at pp. 14-76.

91 See text accompanying n. 40 above.
92 See Olympian Depths, supra n. 40, at p. 13.
418 Wolf-Georg Ringe EBOR 14 (2013)

to consider ousting the chairman at the time.93 Also, it seems doubtful that reputa-
tional constraints really work.94
Lawmakers have suggested the obvious solutions, for example, to strengthen
liability standards or to incentivise directors financially. Whatever the approach, it
is positive that this aspect of the debate to consider the incentives side has now
reached the mainstream policy discussion. It has too often been neglected in the
traditional debate.

4.4 Substitutes for independence

Independence as a regulatory tool may not be the only mechanism for achieving
the particular objective for a specific situation; indeed, it may well be that lawmak-
ers prefer alternative means or substitute mechanisms. This aspect is frequently
overlooked in the policy debate. However, it is fundamental to any meaningful
legal comparison. For example, in a transnational comparison, observers frequently
note the notable absence of independent directors in Japanese companies, as already
noted above.95 Such superficial analysis does however not take into account that
Japanese law has strict independence requirements for statutory auditors, at least
half of whom must be independent.96 They may fulfil some of the objectives that
independent directors do in other jurisdictions.
Germany is another example of a country with a certain reluctance to introduce
far-reaching independence requirements. This certainly has to do with the specific
German issue of worker representation on the (supervisory) board of large compa-
nies, as well as with the concentrated shareholder environment. Following our
rationale developed above, we would expect independent directors, as necessary
counterweight, to voice the concerns of minority shareholders.97 And yet, as de-
plored by the European Commission,98 German law does not specify strict inde-
pendence standards and only vaguely requires the supervisory board to include
what it considers an adequate number of independent members.99 However, any

Back to the Drawing Board, supra n. 41.

93

Bainbridge, supra n. 4, at pp. 95-97.

94
95 See above section 2.2.
96 Enriques, Hansmann and Kraakman, in Kraakman, et al., supra n. 46, at p. 65. See on

board independence in Japanese companies, C. Liu, J. Liu and K. Uchida, Do Independent

Boards Effectively Monitor Management? Evidence from Japan During the Financial Crisis, in
W. Sun, J. Stewart and D. Pollard, eds., Corporate Governance and the Global Financial Crisis:
International Perspectives (Cambridge University Press 2011) p. 188.
97 See above section 4.1.
98 Commission Staff Working Document, Report on the Application by the Member States of

the EU of the Commission Recommendation on the Role of Non-executive or Supervisory

Directors of Listed Companies and on the Committees of the (Supervisory) Board, 13 July 1021,
SEC (2007) 1021, at p 7.
99 German Corporate Governance Code (2013), supra n. 55, section 5.4.2.
Independent Directors After the Crisis 419

criticism of this vagueness does not take into account the substitutes for minority
protection offered by German statutory law. Above all, there is the well-known
group law (Konzernrecht), providing for a statutory system of compensation or
damages payments for minority shareholders in group situations.100 Another substi-
tute for protecting monitory shareholders might be the very strict understanding of
shareholder equality in German law 101 and the far-reaching possibility to chal-
.

lenge the validity of shareholder resolutions.102 The insistence of regulators to

introduce Anglo-Saxon standards of independence in German company law has
therefore led to criticisms, arguing that this would fundamentally misunderstand the
underlying concepts of German law.103
Finally, consider the situation in the UK, where independent directors should
have a role in representing shareholders interests in general as against manage-
ment, following our rationale developed above.104 Although the conflict situation
resembles the starting point in the US, research shows that UK boards employ
significantly fewer independent directors than their US counterparts.105 A superfi-
cial comparison, therefore, would conclude that UK boards should generally in-
crease the proportion of independent directors. This, however, disregards the much
stronger rights of shareholders to remove and appoint board members.106 In the UK,
shareholders can remove directors at will with a 50% majority requirement. Argua-
bly, this power (and already the threat of using it) makes management much more
accountable to shareholders than US law. Again, we see that the mere number of
independent members on the board as such is not a meaningful element of a sound
legal comparison.

100 Aktiengesetz 15-18 and 291-317. See L. Enriques, G. Hertig and H. Kanda, Related-

Party Transactions, in Kraakman, et al., supra n. 46, at pp. 176-178; P. Hommelhoff, Protection
of Minority Shareholders, Investors and Creditors: The Strengths and Weaknesses of German
Corporate Group Law, 2 European Business Organization Law Review (EBOR) (2001) p. 61;
Forum Europaeum Corporate Group Law, Corporate Group Law for Europe, 1 EBOR (2000) p.
165.
101 Aktiengesetz 53a. See L. Enriques, H. Hansmann and R. Kraakman, The Basic Gov-

ernance Structure: Minority Shareholders and Non-Shareholder Constituencies, in Kraakman, et

al., supra n. 46, at pp. 96-99.
102 Aktiengesetz 241-249.
103 M. Peltzer, Fr einen schlankeren Kodex! Kritische Evaluierung der Stellungnahme des

Handelsrechtsausschusses des Deutschen Anwaltsvereins zu den Reformvorschlgen der DCGK

fr den Kodex, NZG (2012) p. 368, at p. 370; N. Paschos and S. Goslar, Unabhngigkeit von
Aufsichtsratsmitgliedern nach den neuesten nderungen des Deutschen Corporate Governance
Kodex, NZG (2012) p. 1361, at p. 1362.
104 See above section 4.1.
105 See L.A. Bebchuk, The Case for Increasing Shareholder Power, 18 Harvard Law Review

(2005) p. 833, at pp. 847-850.

106 See, in particular, Companies Act 2006, s 160.
420 Wolf-Georg Ringe EBOR 14 (2013)

5. TOWARDS A FUNCTIONAL UNDERSTANDING OF BOARD INDEPENDENCE

The insights developed above now allow us to develop a concept of functional

independence of directors. Central to this theory is the understanding that inde-
pendence is not a panacea, and certainly not an end in itself. Rather, it is submitted,
independence is a tool for solving a specific problem. On a very general and ab-
stract level, it is a procedural instrument to protect weak groups within the company
and to mitigate agency costs. As we have seen, it might work to the benefit of
shareholders in general (dispersed shareholder environment) or minority sharehold-
ers, as opposed to controlling shareholders (concentrated shareholder environment).
The important point then is to understand that independence needs to be designed in
accordance with the corporate environment and the specific purpose it is designed
for in a given jurisdiction.
This allows us to develop the following cornerstones for a functional under-
standing of director independence.

5.1 Improving independence

First, independence should be functional in respect to its purpose. Lawmakers avail-

ing themselves of the instrument of board independence should carefully consider
what role the concept should play in their jurisdiction. This should include taking into
account the typical or prevailing shareholder structure and industry structure in the
jurisdiction. As we have emphasised, one fundamental (yet coarse) distinction is the
traditional divide between concentrated and dispersed ownership, where the focus of
independence should lie on strengthening, respectively, minority shareholders or
shareholders generally.107 This will have far-reaching implications for the respective
definition of independence, in particular whom the director should be independent of
(majority shareholder versus board). At the same time, as we have shown, lawmakers
should respect and/or complement pre-existing equivalent substitutes. If adequate
safeguards are already in place, additional independence standards will not be neces-
sary and may even be counterproductive. It is in line with this argument to emphasise
the importance of independence particularly in situations where conflicts of interests
are most salient, for example, in the appointment or removal of managers, when
setting executive pay, or when auditing executive performance.
It is against this background that we can make predictions of the usefulness of
different independence criteria against the specific situation in any given jurisdic-
tion. To illustrate, the recent review of the German Corporate Governance Code

107 See above section 4.1. Note, however, that the distinction between concentrated and

dispersed shareholder structure is a simplification; in practice, many mixed situations or

variants exist, see R. Gilson, Controlling Shareholders and Corporate Governance: Complicating
the Comparative Taxonomy, 119 Harvard Law Review (2006) p. 1642.
Independent Directors After the Crisis 421

to include independence from a controlling shareholder can be said to be a step

in the right direction (the technical details are still debated).108 By contrast, the fact
that the UK Code lists as one of its independence criteria the absence of any links
with a significant shareholder must be surprising, given the highly dispersed share-
holder structure in this country.109
Secondly, in order for independence to be functional, it needs to address its very
own weaknesses. As recent empirical research has shown, independence is often
associated with ignorance.110 Lawmakers should therefore ensure that independence
is accompanied and supplemented with proper expertise or appropriate ongoing
training. This could, for example, be monitored through regular external control.
Apart from expertise, avenues that regulators should explore could include raising
the accountability of independent directors to shareholders or minority shareholders
this argument is further developed below.111 Alternatively, monetary or non-
monetary incentives could be introduced by law, for example, specific target
benchmarks. These measures should address the low incentives to engage with the
company that we currently see among directors.

5.2 Combining independence with dependence

Thirdly, lawmakers should think about coupling independence with dependence.

What sounds like a contradiction is designed to achieve the following: independ-
ence is usually framed as a negative criterion independence from some group or
person, for example. The downside to this approach is that independence is
ambiguous as such: a passive concept, bare of any positive, proactive element. The
policy discourse would benefit from more experimenting with dependent or
accountable directors who would represent the constituency which the legal rules
intend to protect. To make this more concrete: minority shareholders in a concen-
trated ownership system are currently very much at the mercy of low-incentivised
independent directors. If, however, such independent directors were at the same
time associated with a specific constituency, they would have a more meaningful,
positive role. For example, a director could at the same time be independent of a
controlling shareholder, but accountable to minority shareholders. This is what is
intended by minority appointment rights, as exist in, for example, Italy. Italian
company law mandates board representation for minority shareholders in listed
companies through an elaborate system of board lists.112 Since 2007, all listed

108 The 2012 amendment of the German Corporate Governance Code revised its section 5.4.2

in this sense. See supra n. 56 and accompanying text.

109 UK Corporate Governance Code, supra n. 52, section B.1.1. See above section 4.1.
110 Beltratti and Stulz, supra n. 2.
111 See below section 5.2.
112 Art. 147-ter Consolidated Law on Finance, available at: <http://www.consob.it/mainen/

documenti/english/laws/fr_decree58_1998.htm>.
422 Wolf-Georg Ringe EBOR 14 (2013)

companies are required to reserve at least one board seat for candidates drawn
from slates submitted by minority shareholders; consequently, even investors
holding a comparatively small block of shares can have access to the board.113 It is
encouraging that the European Commission, in its latest Green Paper on Corporate
Governance, mentions the Italian system as a good example of making the board
more accountable to minority shareholders.114 Another example is the well-known
and much-discussed German system of employee representation on the board.
Similarly to how the Italian law protects minority shareholders, the German law
takes care of employees. It is important to note, however, that these appointed
directors have duties and liabilities like any other director, including in particular
the duty to protect the interests of the company as a whole. Nevertheless, their
position as appointed representatives of a certain group facilitates information flows
between the company or management and the represented group (in both direc-
tions), and helps ensure that the concerns of this group are at least heard and con-
sidered at board level, thus raising awareness of their positions and encouraging
discussions. All of this would be very much in line with the strand of research that
has become known as the theory of the board as a mediating hierarch, in the sense
that the board as an institution brokers the relationship between the various differ-
ent constituencies affected by the company.115
Transferring this line of reasoning to the US/UK context of corporate govern-
ance, where ownership is more dispersed, independent directors should not just be
independent of management, but, to some extent, be accountable to the sharehold-
ers as well. This has been advocated already some time ago, but is not reflected in
the current legislative framework.116 Indeed, some argue that boards should be more
accountable to shareholders, relying on empirical data from the financial crisis.117
Moreover, improving the representation of shareholders or minority groups on
the board would have positive side effects. Looking at the weaknesses of the typical
current independent director as discussed above,118 there is a good chance that, for

113 See on this, B. Espen Eckbo, et al., Efficiency of Share-Voting Systems: Report on Italy,

ECGI Law Working Paper 174/2011, available at: <http://ssrn.com/abstract=1431733>;

M. Belcredi, S. Bozzi and C. Di Noia, Slate Voting in Board Elections: Evidence from Italian
Experience, EALE Working Paper (March 2012), available at: <http://www.eale.org/conference/
eale2012/paper/view/431/84>.
114 European Commission, Green Paper: The EU Corporate Governance Framework, supra n.

25, section 2.7.1.

115 M. Blair and L. Stout, Director Accountability and the Mediating Role of the Corporate

Board, 79 Washington University Law Quarterly (2001) p. 403; and M. Blair and L. Stout, A
Team Production Theory of Corporate Law, 85 Virginia Law Review (1999) p. 247.
116 Gilson and Kraakman, supra n. 44, at p. 865.
117 See B. Francis, I. Hasan and Q. Wu, Do Corporate Boards Affect Firm Performance?

New Evidence from the Financial Crisis, Bank of Finland Research Discussion Paper No.
11/2012, at p. 35, available at: <http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelu
aloitteet/Documents/BoF_DP_1211.pdf>.
118 See above section 4.
Independent Directors After the Crisis 423

example, group representatives would have better expertise simply because the
minority group would make sure they put forward a candidate who best represents
their interests in a sophisticated manner. Similarly, we can expect that the incentive
problem will be mitigated: directors who directly represent a specific group will
have a much stronger incentive to pursue a certain agenda than the empty, disin-
terested standard director. It may be hoped that this will result in an open, fresh
dialogue: the ultimate goal would be for representative directors to present new
arguments and possible strategies to their fellow independent directors and argue
for certain ways forward, informing and inspiring the entire board and ultimately
benefiting the entire company.
On the other hand (nothing in excess). It would have fatal conse-
quences were the board only composed of representatives of certain interest groups.
This could lead to overprotection and overrepresentation of (potentially different)
minority groups and activists, blocking an effective organisation of and decision
making by the board. The consequence would be trench warfare and deadlock in
decision making. It is moreover beneficial to have a proportion of truly independent
outsiders on the board, as they can overcome groupthink and bring in new, fresh
ideas. A good balance is essential and a mixture of all of these groups is desirable.
The ultimate tenet must be the one from the former Combined Code,119 which
insists that an appropriate balance of directors is essential such that no individ-
ual or small group of individuals can dominate the boards decision taking.120
These simple words aptly describe the objective of board composition, better than
many lengthy articles.
In sum, this paper supports the idea to combine board independence with a cer-
tain, balanced dependence on (or accountability towards) certain constituencies and
stakeholders. We have seen that the following benefits are to be expected. First,
having a representative on the board will be a direct tool to voice the concerns of
the protected group (minority shareholders, for example) and to raise awareness for
their positions. Secondly, certain weaknesses that independent directors have
shown during the financial crisis may be overcome, notably expertise deficits and
incentive problems. Having appointed representatives with a clear agenda on the
board will ensure that these individuals are better incentivised and experienced.
Thirdly, an indirect impact may be expected on the incentives of the other, non-
appointed directors. Being exposed to new, clearly formulated arguments and
(sometimes contrasting) positions within the board dialogue will stimulate more
controversial thinking, improve the quality of the dialogue and raise the general
standard of discussions. This will enhance the standard of board activity overall, to
the benefit of the company as a whole. Fourthly, representative board members

119 The Combined Code of Corporate Governance is the predecessor of todays UK Corpo-

rate Governance Code.

120 Now UK Corporate Governance Code, supra n. 52, section B.1.
424 Wolf-Georg Ringe EBOR 14 (2013)

stand to improve information flows beyond the board even if they cannot always
force through their position, they can at least raise awareness of the views of minor-
ity groups. Conversely, they can also improve the information stream by reporting
back to their principals about deliberations in the board and thus contribute to more
transparency within the company.

6. CONCLUSION

The dismal performance of many companies during the financial crisis has re-
opened the debate on board corporate governance, and in particular on the long-
established element of director independence. Many current initiatives and policy
discussions seem to suggest that they aim to strengthen independence, thus a clear
more of the same. By contrast, this paper calls for a reflection on the inherent
purpose of director independence and develops a functional notion of director
independence, overcoming its deficiencies.
This is against the background that independence is often used in an undiffer-
entiated way, lacking a clear, unambiguous definition. This complicates in particu-
lar cross-border comparisons. This paper suggests that it is necessary to perform an
analysis not only of the notion of independence, but also of the concept. Thus,
independent directors are understood as a means to better control the management
and to mitigate agency costs by protecting minority groups. The specific role that
independent directors have to play depends on the specific jurisdiction, in particular
on the business environment, shareholder structure and industry characteristics. It is
therefore crucial to determine of whom the director should be independent.
But, this paper argues, independence as such is not enough. The second step is
that independence should be carefully balanced with a certain amount of depend-
ence. This refers to accountability of directors to certain minority groups which
they should protect. Strengthening the accountability of directors promises to
overcome certain weaknesses that they have displayed over the past years, most
notably expertise and incentive problems. Minority shareholder appointment rights
in Italy are an example of a useful concept in a concentrated ownership environ-
ment. The corresponding tool for a more dispersed ownership scenario would be a
director directly appointed by the shareholders.
Overall, the challenge is to find the right balance between independence and de-
pendence. Independence from the controller (management and/or majority share-
holder) should be guaranteed, but a certain accountability to the underrepresented
group would be an equally important component in motivating and stimulating the
board to perform a meaningful role.
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