Governance Explainer Director Independence

Two shareholder advisory groups, ISS and Glass Lewis, urged investors to vote against McDonald due to concerns about his independence as he had been on the board of THG since 2010.

His 13-year tenure had extended far beyond the 9 years recommended by the UK Corporate Governance Code as the maximum during which a director can be considered independent.

In May 2023, shareholders in Illumina, the world’s biggest gene sequencing company, ousted John Thompson, chairman, and approved a nominee supported by Carl Icahn following a bruising proxy battle led by the veteran activist investor.

Icahn alleged that Thompson and former chief executive, Francis deSouza, championed a “reckless decision” to close Illumina’s $8bn acquisition of cancer test developer Grail in 2021 against the wishes of EU and US competition regulators.

The investor also alleged Illumina’s board lacked independence and most non-executive directors were handpicked by deSouza.

These cases illustrate the hot water that boards can get into if powerful investors believe companies are run by a board that lacks perceived independence, and are perhaps too closely entwined with the CEO or major shareholders.

What the Code says

In principle, all UK directors are required to exercise independent judgement. This is set out clearly in section 173 of the Companies Act 2006.

The intention behind this law is that directors should maintain a laser-like focus on making the best decisions for their company, and not be distracted by other considerations.

However, in the real world, directors may be enmeshed in all kinds of roles and relationships which may affect their perceived objectivity. These include things like family relationships, close friendships, and other business activities.

In an effort to manage these perceived conflicts of interest, the UK Corporate Governance Code requires the boards of premium-listed companies to identify in the annual report each director it considers to be independent.

It provides a list of criteria which can be used to determine if a director is independent or not – although it also accepts that a board may wish to justify independence on other grounds as long as a clear explanation is provided.

Most importantly, the Code recommends that at least half the directors on the board, excluding the chair, are ‘independent’.

This does not rule out ‘non-independent’ persons from serving on boards. It just means that they should be in the minority.

Defining director independence

According to the Code, circumstances that are likely to impair a director’s independence include:

• is or has been an employee of the company or group within the last five years. This means that current executive directors would automatically fail the independence test. Only non-executive directors can be classified as independent. Worker directors would also not be perceived as independent.
• has, or has had within the last three years, a material business relationship with the company, either directly or via another company.
• has received or receives additional remuneration from the company apart from a director’s fee. This automatically excludes people who work as consultants for the company. It also rules out directors receiving share options or performance-related pay.
• has close family ties with any of the company’s advisers, other directors or senior employees.
• holds cross-directorships or has significant links with other directors through involvement in other companies or bodies. Hence if a subsidiary board appoints someone from elsewhere in a corporate group, they would not be considered independent.
• represents a significant shareholder.
• has served on the board for more than nine years from the date of their first appointment.

Does director independence make a difference?

The emphasis on director independence has been one of the biggest trends in corporate governance over the last two decades.

The boards of most large UK and US companies are now overwhelmingly composed of directors that self-identify as ‘independent’.

The intention behind the trend has been to promote more objective and impartial decision-making. But has this resulted in boards that produce a better outcome for their organisations?

Not necessarily. There is no guarantee that a director that is defined as ‘independent’ will have the expertise and experience to be an effective director.

Independent directors may also lack the personal characteristics required to think in a truly independent manner – even if they tick all of the independence boxes.

Hence director independence should probably be regarded as a necessary but not a sufficient condition for good directorship. Independence, by itself, is not enough.

And sometimes persons who cannot be defined as ‘independent’ can still bring a great deal of value to boards.