[co-author: Rob Sligh]
This blog post explores when independence is important on a family business board and who can qualify as independent.
Legal Circumstances in Which Independence Is Important
The "business-judgment rule" is a presumption that in making business decisions the directors or managers acted or chose not to act on an informed basis, in good faith and with the honest belief that the decision was in the best interests of the enterprise. A court will not second-guess a business decision under the application of this presumption.
To have the benefit of the "rule" and avoid legal liability for decisions, a director or manager must act in good faith, not be interested in the subject of the business decision, be informed regarding the matter, and have an honest and rational belief that the decision is in the best interests of the enterprise.
If the directors are interested in a matter or conflicted, the board and its members will not have the benefit of the rule if there is to be judicial review of the decision. The burden of proving that the decision was informed, in good faith and was made with an honest belief that it was in the best interests of the enterprise will rest on them. Generally, where there is a conflict of interest or an interest in the outcome, the burden is very difficult to satisfy.
However, a decision involving a conflict of interest or interested directors may be respected if the action is approved by a majority of independent directors, who have acted in a manner to satisfy the requirements of the rule. Independence also is required when a board appoints a "special committee" to evaluate a decision regarding a conflict in a transaction or in response to a shareholder filing a derivative action.
Independence from a Legal Perspective
One jurisdiction considers a director as "independent" if the director does not have either a) a conflicting interest in the transaction or b) a familial, financial, professional or employment relationship with another director who does have a conflicting interest (a relationship that would, under the circumstances, reasonably be expected to exert an influence on the first director's judgment).
Independence exists where the director's decision is based on the merits of the matter and not on other considerations or influences. If a director has a sense of being indebted to an interested director, the director will not be considered "independent." Such a sense has been found where one director got the benefit of a price from another director in a separate matter; where a cousin felt a sense of duty to another director; and where there are significant social or professional relationships that could be reasonably expected to exert influence on a decision.
As such, the legal standard is a "fact and circumstances" analysis by the court, with the burden of showing independence on the board member or committee.
Family Business Consulting Perspective
Many members of the "Now Generation" seem to feel they wouldn't want people from the outside serving on their boards and bossing them around. This of course reflects both an underappreciation of the majority owner's power to elect directors and the director role, which is most importantly to share experiences that may resonate and ask insightful questions likely to prompt positive reflection and action. Yet years afterward, most business owners feel that establishing a board with independent directors was one of the best decisions they ever made.
On average, in the long run, family-owned businesses outperform private equity-owned companies – and both outperform public companies. Private businesses that have three or more independent directors perform even better. Beyond performance outcomes, independent directors inspire trust among shareholders, other board members and company leaders because of their unconflicted interest in doing what's best for the shareholders as a whole, now and for the long run. There are many areas in which independent directors typically contribute to the success of a family-owned business, including:
- shareholder returns, risk and liquidity
- ownership interests and ownership succession
- CEO selection, compensation, evaluation and succession
- oversight of top leader development, feedback processes, compensation and succession
- strategic planning and competitive positioning
- sources and uses of capital
- sounding board for important initiatives, divestitures and acquisitions
- supportive guide, validator and accountability forum
- stewards for company culture
What Is an Independent?
Here are independence standards of the type typically used for family business boards. A director will be presumed to be independent if the director of XYZ Company:
- is not an existing XYZ owner or the spouse of an existing owner or an immediate family member or descendant, or spouse of same, or the beneficiary of any trust established by persons described above, or the executor, administrator or personal representative of any person described above who is deceased or legally incompetent
- has not been employed by XYZ in the past three years
- is not affiliated with a significant customer or supplier of XYZ
- is not an advisor or consultant to XYZ and is not employed by or affiliated with a company that is an advisor or consultant to XYZ
- has no personal service or consulting contracts with XYZ
- is not employed as an executive of another company where any of XYZ's owners or leaders serve on that company's board of directors
- is not an immediate family member of an individual who is, or has been during the past three years, employed by XYZ as an executive officer
- is not a financial partner with a XYZ family member in another property or business venture