# **_How to ensure director independence?_**

The mechanisms through which director independence can be ensured fall at least into four large categories (see Box 4 for the definition of independence). The first one is to tighten the standards and rules of disqualifying relationships, including current employment by the firm and dimensions of potential connectedness. Throughout the 80s and 90s, panels and “blue ribbon” committees developed influential “best practice” guidelines for relationship tests. The American Law Institute (ALI)’s 1992 Principles of Corporate Governance recommended that the Board of a public corporation “should have a majority of directors who are free of any significant relationship with the corporation’s senior executives.” “Significant relationship” was defined in a way to disqualify many affiliated directors, both through categorical exclusions relating to the firm’s principal outside law firm or investment bank, and through attention to customer/supplier relationships crossing a relatively low (U$200,000) economic materiality threshold. The NYSE 2005 corporate governance standards: “no material relationship with the listed company ... including as a partner, shareholder or officer of an organization that has a relationship with the company”.

## **<mark>Box 4 Definition of Independence</mark>**

<mark>In some countries such as New Zealand, independence means only non-executive. In a number of countries, independence is meant both from the management and from business relationships. This is the case in Australia and in Norway, where private sector experts are not supposed to have any business relation or be in competing business. “Independence” in US state corporate law means only disinterest in a particular conflict of interest transaction. State corporate law attempts to deal with such transactions generally through disclosure to and approval by directors who are not involved in the transaction. It does not require the institution of abstractly independent directors. Instead, it takes a transaction-by-transaction approach. While the concept of the disinterested director is constantly being tested and refined through litigation, there is virtually no jurisprudence on who counts as an independent director for the purposes of the federal laws and regulations calling for them. Disinterested directors are a concept in Delaware’s corporate law, and Delaware has courts and a responsive legislature that sees problems and responds to them. The NYSE rules and SOA, by contrast, carry with them no system for resolving disputes through a fair process resulting in written decisions. The exchanges have only the blunt tool of delisting for the enforcement of their rules. Finally, some countries such as Australia have a broader approach to the independence of Boards. They take into consideration not only the independence of Board members, but also the separation of the Board Chairman from the CEO. It is then the role of the Board to select the CEO, although responsible Ministers are consulted as part of this process. According to the principles in the 2005 EC Recommendation a director is considered independent when free from any business, family or other relationship - with the company, its controlling shareholder or the management - which might jeopardize his or her judgment. The (supervisory) Board should be composed of members who, taken together, have the diversity of knowledge, judgment and experience to properly complete their tasks. All directors should devote to their duties the necessary time and attention. When the appointment of a director is proposed, his or her other significant professional commitments should be disclosed.</mark> _<mark>Source:</mark>_ <mark>Clarke (2006) and EC (2005)</mark> A second mechanism for independence is to increase penalties and incentives, such as legal liability for fiduciary duty breach, reputational sanctions, and stock-based compensation **.** The most powerful stick has been in practice the risk of monetary liability for breach of the state law duty of care, which fosters director independence by requiring director attention to the business and affairs of 6