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Independent Director

A director with no material relationship with a company

What is an Independent Director?

An independent director, in corporate governance, refers to a member of a board of directors who does not have a material relationship with a company and is neither part of its executive team nor involved in the day-to-day operations of the company.

 

Independent Director

 

Summary:

  • An independent director is a member of the board of directors who (1) do not have a material relationship with the company, (2) is not part of the company’s executive team, and (3) is not involved with the day-to-day operations of the company.
  • To be able to list on certain exchanges, there are requirements for the number of independent directors on the board.
  • A material relationship is a relationship that can interfere with the exercise of a director’s independent judgment.

 

Independent Directors – A Requirement to List on a Stock Exchange

Depending on the stock exchange, there are requirements for the number of independent directors that must comprise the board. For example, the New York Stock Exchange (NYSE) requires that (independent) directors comprise the majority of the board. For this reason, understanding the definition of an independent director is important to avoid violating any rules.

The NYSE’s and the NASDAQ’s respective definitions are as follows:

NYSE:  “Independent director” is one who the board “affirmatively determines” has no “materiality relationship” with the company “either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company.”

NASDAQ: ““Independent director” is one who is not an executive officer or employee of the company, and who, in the board’s opinion, has no relationship which would “interfere with the exercise of independent judgment” in carrying out director responsibilities.”

 

Although the NYSE and the NASDAQ define the term slightly differently, the underlying message is that an independent director must not have a material relationship with the company it boards or have a material relationship with a related company that conducts business with the company. A material relationship is a relationship that can interfere with the exercise of a director’s independent judgment.

 

Potential Benefits of Appointing Independent Directors

Independent directors are generally desirable to be appointed to the board of directors and are key to good corporate governance.

A board that is majority independent would be better suited to oversee the CEO as opposed to a board comprised of dependent directors. Additionally, appointing more independent directors generally results in greater third-party advice and expertise (due to the executives coming from different backgrounds). Since the directors, by definition, do not have a material relationship with the company, they are not subject to undue influence from the management team.

 

Potential Drawbacks of Appointing Independent Directors

In addition to the potential benefits, there are a number of drawbacks to consider.

One example is the risk of information asymmetry as independent directors are generally less informed about the company than the management team. Although a director may be independent by definition, it does not imply that the director is acting in absolute independence – independent directors can be co-opted by management. In addition, they may not have the requisite skills and knowledge to be an effective board member.

 

Board Independence for S&P Companies

As reported by the Wall Street Journal (WSJ), the vast majority of board members for S&P 500 companies are deemed independent under stock-exchange rules. The following is a graphic provided by the WSJ:

 

Board Independence for S&P Companies

 

Companies with a 100% independent board

The three black circles in the graphic above refer to companies with an independent board of directors only. The three companies are McDonald’s, Kraft Heinz, and Transocean.

 

Companies with a 50% or less independent board

Companies with half, or less than half, of their board comprised of independent directors include News Corp, Urban Outfitters, Expedia, Essex Property Trust, Kinder Morgan, Brown-Forman, Fidelity National Information Services, Diamond Offshore Drilling, and Cablevision Systems.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Board of Advisors
  • Company Bylaws
  • Fiduciary Duty
  • Staggered Board

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