Friday Editorial: Director Duties, Independent Boards, and the Removal of CEOs

On Monday, Oct. 22, the Journal included an article on the difficulty confronted by boards in removing CEOs.  There is little doubt that oversight of the CEO is a critical if not the most critical function of the board of directors.  Nor is there any doubt that removal is one of the most difficult decisions a board must make.  A fall in earnings or share prices in general does not justify the step.  Moreover, as the article noted, the decision sometimes depends on the availability of an adequate replacement.  Whatever a board does, some will always disagree with the decision.

The issue of removal, therefore, is unique for each company and each board.  Except in extreme cases, resolution turns on the integrity of the process.  The question is whether there is a board of directors in place that is truly watching out for the best interests of shareholders.  If so, then an early or delayed removal of a poorly performing CEO will flow from the board's perception as to what is best for shareholders.

But the integrity of the process presupposed a significant number of independent directors.  Certainly this is the trend, with the stock exchange requiring boards to have a majority of independent directors and Delaware courts giving such boards clear legal benefits.  Yet the notion that boards are independent is often a charade.  The definitions do not screen for friendship, do not factor in the materiality of directors fees, and, where directors are associated with non-profits, largely disregard contributions from the company or its employees.

Some of this information is in the public domain.  The Commission's reforms of executive compensation put in place last year require companies to report the total executive compensation paid to outside directors, increasing significantly the transparency of the compensation.  Other information (friendship and outside business relationships) is not.  But even where a director's independence is in doubt because of the amount of charitable contributions or the fees paid, they are still treated as independent and, under Delaware law, their decisions receive an inappropriate degree of deference. 

This does not mean that all boards (or even most boards) lack independence.  Some, however, do.  The evidence can sometimes be seen from the board's output:  Excessive amounts of executive compensation paid to a CEO in a company that is and has been performing poorly.  Couple these outputs with staggered boards, poison pills, and other techniques designed to insulate the directors from challenge and chances are the board is not paying adequate attention.

The only way to ensure independence and oversight is to provide a mechanism whereby shareholders can at least in extreme cases elect their own nominees to the board.  These nominees will be far more likely to examine more closely the CEO's activities.  This is, of course, what shareholder access would do.  It is also the reason why public companies so vociferously fight the proposal.  The last thing underperforming CEOs really want is pro-shareholder directors looking over their shoulders.