Declaring Independence

In the fall of 2004, and with relatively little fanfare, the New York Stock Exchange and the NASDAQ Stock Market imposed new corporate governance listing standards on their member companies, including the mandate that they have a majority of independent directors on their boards. The revised standards were a direct response to a series of high-profile accounting scandals at the likes of Enron Corp., WorldCom Inc., and Adelphia Communications Corp. As such, they have largely been overshadowed by the Sarbanes-Oxley Act, which Congress passed in 2002 for the purpose of making boards of directors more accountable for the integrity of their companies’ financial statements.

Both U.S. and foreign corporations that file regular financial reports with the Securities and Exchange Commissionu00e2u20ac”including banks and thriftsu00e2u20ac”have spent an enormous amount of time and considerable sums of money complying with the requirements of Sarbanes-Oxley. But it’s possible the new NYSE and NASDAQ listing standards will have an equally profound impact on the nature of corporate governance in the years ahead because in effect, they place a corporate board’s most important decisions under the control of independent directors.

Ultimately this could mean boards of U.S. banks and thrifts listed on the New York and NASDAQ exchanges will start to be shaped not by the chief executive officeru00e2u20ac”which has traditionally been the caseu00e2u20ac”but by outside directors themselves. Although some CEOs may feel threatened by this loss of control, others find the experience of working with a diverse board of outside directors invigorating. One of those is Jay Sidhu, chairman and CEO at Philadelphia-based Sovereign Bancorp.

Traded on the NYSE and ranked as the third-largest thrift in the country with assets of $58 billion, Sovereign’s board has consisted entirely of independent directorsu00e2u20ac”except for the CEOu00e2u20ac”since 1989. Sovereign has an unusually small board for a company of its sizeu00e2u20ac”just six directors, including Sidhu. Still, the bank’s five outside directors have a broad range of experience in a variety of businesses; all have run their own companies, including ex-banker Andrew C. “Skip” Hove Jr., who served as acting chairman of the Federal Deposit Insurance Corp. in the 1990s. Sidhu says he values his directors’ adviceu00e2u20ac”particularly as it reflects their diverse backgrounds. “The more diverse the opinion, the better,” he says. “It’s a fantastic environment.”

The new standards’ impact may be more evolutionary than revolutionaryu00e2u20ac”more Darwinian than Marxian in natureu00e2u20ac”since most public companies prefer stability in the corporate boardroom and usually add new directors only when incumbents retire or resign of their accord. And not every large bank or thrift will go as far as Sovereign and ban all inside directors except for the CEO. But from now on, many industry CEOs will have to learn to deal with boards of directors that are no longer liberally seasoned with cronies and insiders. Sidhu says good CEOs don’t need them. “If you’re insecure, if you’re incompetent and need alliesu00e2u20ac”then you’ve got bigger problems.”

In addition to having a majority of independent directors, the new NYSE standards require all nonmanagement directorsu00e2u20ac”including those who do not meet the technical definition of independenceu00e2u20ac”to hold regularly scheduled executive sessions without management. The NYSE standards also mandate that all companies have audit, compensation, and nominating/corporate governance committees comprised solely of independent directors.

NASDAQ imposes essentially the same requirements with one notable exception. NASDAQ does not require its companies to have a standing nominations committeeu00e2u20ac”although if they do, only independent directors may serve on it. And if a NASDAQ company does not have a standing committee to handle director nominations, candidates must be selected by a majority of independent directors.

Both exchanges also tightened up their technical definitions of “independence.” Disqualifying factors include any employment relationship with the company over the previous three years, a variety of familial relationships with members of management or the board, or the receipt of various kinds of monetary payments over a certain amount.
“The spirit of the exchange standards is that boards should be largely independentu00e2u20ac”and the key committees should be totally independent,” says Anne Yerger, executive director of the Council of Independent Directors.

On their face, these new requirements might not seem to add up to very much. Sarbanes-Oxley already requires all SEC filing companies to have an independent audit committee. And well before that, the FDIC Improvement Act of 1991 imposed the same requirement on all insured depository institutions with assets of $500 million or more. Although statistics are difficult to come by, it’s also likely most large banks and thrifts already had a majority of independent directors, though it’s not an uncommon practice in the industry to have as many as three inside directors.

The requirement that may have the greatest impact on boardroom politics in the years to come is the necessity to form an independent nominating committee. Not everyone who meets the technical definition of independence is necessarily independent in spirit. It has been a longstanding practice at many banks for the CEO to take the lead in recruiting new directors. Even when he was not literally trying to pack the board with allies and really was searching for qualified candidates, the CEO often looked for individuals with whom he had some past experienceu00e2u20ac”in other words, people he felt he could work with.

Some level of collegiality is an important ingredient in effective corporate governance, but in the minds of many governance experts, the ability of the CEO to influence the selection of director nominees, for whatever reason, goes to the very heart of the independence issue. “A good board must consider the spirit of independence,” says Robert Bostrom, a New York-based partner at the law firm of Winston & Strawn. The mere fact a director meets either the NYSE or NASDAQ definitions of independence doesn’t mean he or she is free of the CEO’s influence, Bostrom adds. “How independent can these directors be if they’ve been picked by the CEO?” he asks. Thus, for Bostrom, the key issue is, “Who picks the directors?”

Under the new listing standards, the authority to select nominees for shareholder ratification clearly rests with the independent directors. Many independent nominating committees will no doubt take their CEOs’ concerns into consideration and might involve them in the interview processu00e2u20ac”but they are not required to do so. And that’s fine with Jerry Grundhofer, chairman and chief executive officer at Minneapolis-based U.S. Bancorp, the country’s seventh-largest bank with $192 billion in assets.

Grundhofer is the only insider on his 15-person board, an all-star group that includes Peter H. Coors, chairman of the Adolph Coors Co., and Patrick T. Stokes, president and CEO of Anheuser-Busch Cos. (U.S. Bancorp is an NYSE-listed company and one director does not meet the exchange’s technical definition of independence, although all other nonmanagement directors are independent.) The bank’s independent governance committee was overseeing new director recruitment even before the new listing standards took effect, and Grundhofer says its members are not required to consult him or allow him to interview prospective candidates before they are recommended to shareholders for election to the board, although he will do so if asked. “It’s fine either way,” he says. “I’d be happy to go with their choice if they didn’t ask me.”

Sovereign’s independent nominating committee has exercised sole authority over director nominees since 1989. According to Sidhu, the entire board agrees on the process by which prospective directors will be recruited and then the chairman of the nominating committee oversees that process. Although this approach gives Sidhu an opportunity to voice his concerns to the full board, he does not have veto power over prospective nominees. “I don’t have veto power over anything,” he says. “I wouldn’t want veto power over anything. No single director should have veto power.”
As independent corporate governance committees exert greater control over the nominating process, one possible ramification could be a gradual reduction in the number of inside directors who serve on bank and thrift boards. Neither Grundhofer nor Sidhu express any reservations about being the only management director on their boards.

Like many institutions today, U.S. Bancorp has had more than one inside director in the past, including a few years ago when Jack Grundhoferu00e2u20ac”Jerry’s older brother and his predecessor as CEOu00e2u20ac”served on the board at the same time. The present-day company was formed five years ago through the merger of Firstar Corp., where Jerry Grundhofer was the CEO, and the legacy U.S. Bancorp, run by his brother, Jack. As often happens after large mergers, the combined bank ended up with a very large board that included insiders from both organizations. In the years since, the board has gradually been reduced to its current size, leaving the CEO as the lone insider. Grundhofer prefers it that way.

“I think it’s a very healthy process not to have more than one [insider],” he says. Grundhofer believes inside directors below the CEO are too often compromised by their obvious ties to the boss. “I think they can be good directors, and I’m sure there are companies where they are,” he says. But in an environment where institutional investors want to see more director independence, says Grundhofer, “Who needs to bring that aspect of conflict into the boardroom?”

Sidhu, however, is adamant in his assertion that insiders below the level of CEO do not belong on the board. Sovereign maintains both an office of the chairmanu00e2u20ac”which includes the company’s top five officersu00e2u20ac”and a larger management committee below that. These groups regularly interact with Sovereign’s directors at board meetings. “It’s very difficult for me to see what benefit you gain from having insiders on the board,” he says. “You can get the benefit of their counsel without having them on the board.”

Bostrom at Winston & Strawn says management directors can find themselves in a compromising position when the board is discussing a controversial issue that has the CEO on one side and one or more independent directors on the other. “In most cases, there is a reluctance to speak openly and honestly against the CEO,” he says. “There’s an unwillingness to speak candidly in front of the board.”

To be sure, there are many other people who are not automatically opposed to the idea of having an inside director such as the chief operating officer, chief financial officer, or head of a major business unit serving on the board. Yerger at the National Council of Institutional Investors says her group does not go so far as to say the CEO should be the board’s only insider, although it would prefer at least two-thirds of the board qualify as independent. And Richard Kovacevich, chairman and CEO at San Francisco-based Wells Fargo & Co., the country’s fifth-largest bank with $421 billion in assets, is also hesitant to assume a priori that other senior managers can’t make good directors.

Kovacevich is currently Wells Fargo’s only inside director, but he cautions against reading too much into that. “It’s not my decisionu00e2u20ac”it’s a board decision as to who it nominates to be a director,” he says. But he is also not opposed to the practice of adding insiders per se. “If having another [insider] added more value, we should do it,” he explains. “And if it doesn’t, we shouldn’t. I think there’s a perception out there that the fewer insiders you have on the board, [the greater your] independence. I don’t happen to agree with that. I think there should be a majority of independent directors. But is one better than two or three? I don’t know. I think one needs to be careful about making a judgment until you know the totality of a situation. It’s really what happens at the [board] meeting.”

At the heart of this debate is a central question: Does having more independent directors result in better corporate governance? Depending on who you talk to, the answer is either yes or no.

Both Sidhu and Grundhofer say the independent directors on their respective boards give them candid advice, and they believe this has raised the level of decision making at both organizations. Sidhu says there have been occasions when his board has persuaded him to change his mind about certain decisions. For instance, Sovereign has done several acquisitions in recent years and in some cases, the board felt it better to pass on a specific opportunity. Sidhu respected their judgment.

For his part, Grundhofer says a strong board filled with independent directors can help keep the CEO from making poor decisions. “CEOs who don’t listen to them, in my view, are making a big mistake,” he says. “I know a lot about the banking business, but they have a wealth of experience. These men and women run big companies, and they’re very independent. There’s not a lot of collegiality from a personal standpoint because there’s not time to get to know them. This is big business. They take [governance] very seriously.”

Not everyone sees quite as strong a connection between director independence and the quality of governance. In the summer 2002 issue of the Harvard Business Review, Jeffrey Sonnenfeld, associate dean for executive programs at the Yale School of Management, wrote an article titled “What Makes Great Board Great?” Sonnenfeld concluded that any number of good governance practices that advocates have been pushing for yearsu00e2u20ac”including more independent boardsu00e2u20ac”are less determinative than a variety of human factors. Those factors include a climate of trust and candor, a culture of open dissent, and individual accountability. Looked at from this perspective, there’s no reason a nine-person board with three inside directors couldn’t be just as effective as one where the CEO is the only insider and everyone else meets a technical definition of independence.

Others who take this position include Rodgin Cohen, the managing partner at New York-based Sullivan & Cromwell. “Independence, in my view, is far more a question of integrity and less of rules,” he says. “People will be independent or not because they’re willing to stand up to the CEO.” Another veteran attorneyu00e2u20ac”Steven Kaplan, a partner who runs the corporate and securities practice at the Washington-based law firm of Arnold & Porteru00e2u20ac”also disagrees with the notion that a board with only one insider provides, ipso facto, better governance. “As with all things in life, it depends on the character, intellect, and integrity of the people involved,” he says. “Most boards we see are run by consensus.”
Thomas K. Brown, president of New York-based hedge fund Second Curve Capitalu00e2u20ac”which specializes in financial services stocksu00e2u20ac”likewise believes too much is made of the independent label. “At the end of the day, good board members are good board members whether they’re independent or not,” he says. Brown believes good directors are those who practice the “nose in, hands off” approach. “A good board member will give his opinion but allow management to do it.”

Two of the strongest proponents of this more flexible approach to independence are the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, which, between them, oversee approximately 7,000 U.S. banks. Their views on the issue of director independence are of particular importance to small, publicly owned institutions that are not listed on the two big stock exchanges.

Because the new standards on director independence come from the exchanges and not regulatory agencies like the FDIC or OCC, they only apply to the industry’s largest institutions that happen to be listed there. According to SNL Financial, a research firm that collects statistics on the financial services industry, 1,262 banks and thrifts have issued equity thatu00e2u20ac”theoretically at leastu00e2u20ac”is available to the public, although many of these stocks are very thinly traded. Of those, 916 institutions file regular financial reports with the Securities and Exchange Commission or one of the four federal banking regulators. This is probably a more realistic gauge of the public market for bank and thrift stocks. And of those 916 filers, 565 are NYSE- or NASDAQ-listed companies. This means the new rules on director independence apply to only about two-thirds of the industry’s publicly owned institutions. What about the other one-third?

Steven D. Fritts, the FDIC’s acting deputy director for policy in the division of supervision and consumer protection, says his agency has no plans to apply similar governance standardsu00e2u20ac”including having a majority of independent directors and fully independent nominating committeesu00e2u20ac”to small public banks that aren’t listed on one of the two major exchanges. “We’re not contemplating moving to a standard that would require that,” he says. Instead, the FDIC emphasizes good business judgment and personal integrity. “We expect directors to have ideas and to express them publicly,” he says. Fritts also believes requiring all banks to have a majority of independent directors would create a hardship for many small community banks that already have trouble finding qualified candidates. “We believe these boards are doing a pretty good job of managing those institutions,” he says.

Staking out a similar position is Karen Kwilosz, director of operational risk policy at the OCC, who says her agency won’t impose the tougher independence standards on the relatively small number of national banks it supervises that are not listed on the two major exchanges. When it comes to director independence, “it really depends on the bank’s size, complexity, and the environment it operates in,” she says. “All these things fall into what makes for a proper board composition.”

So while small public banks will continue to enjoy considerable flexibility in how they structure their boards, most large institutions now must pay greater attention to the independence of their directors. And at an increasing number of banks and thrifts around the country, the independent directors will be running the show.