Independent DirectorExplained & Defined

Lisa Borga
Last Updated: May 13, 2022
Date Published: May 13, 2022

The term independent director refers to a member of a board of directors who does not have a material interest with the company outside of sitting fees from their membership and plays no role in the daily operations of the company or as an executive officer.

Independent directors are an important concept in corporate governance as their level of separation from the company and its operations makes them more likely to act in the interests of shareholders and other stakeholders.

Because independent directors are not a part of the company’s management

Independent Directors Explained

independent director

Independent directors are appointed due to their lack of any material interest or ties to the company outside of their position on the board.

Most stockholders feel that independent directors bring increased performance to a company due to their objectivity.

In many cases independent directors bring with them unique experience as well.

In some cases a company may recruit an independent director with special experience in the industry in which they operate.

Independent directors can in theory act with greater objectivity because they are free of influence from the companies management and do not have to fear losing their job within a company.

In the wake of major scandals in the early 2000s such as the Enron collapse many stockholders and public officials pushed for an increase in the number of independent directors on the boards of large companies.

Generally an individual is considered to be “independent” if they have not worked for the company in the past several years, receive no pay from the company outside of that from sitting on the board, and are not directly related to an individual working for the company.

They must not have a material relationship with any entity doing business with the company as well.

According to Nasdaq Rule 5605(a)(2) an independent director is defined as “to mean a person other than an executive officer or employee of the company or any other individual having a relationship which, in the opinion of the company’s Board, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

Other stock exchanges define the term similarly with some minor differences.

The underlying message however, is the same that an independent director should not have any material relationship with the company to which they will serve on the board of directors which could influence their judgement.

Independent Vs. Inside Directors

In direct contrast to independent directors who do not work for or have material interest in a company stands an inside director.

An inside director in addition to sitting on the board works for, is an officer of, or is a stakeholder of the company.

An inside director may lack the objectivity of an independent director, however, they do offer a direct knowledge of the inner workings of a company, its culture, and any issues it may be facing.

Commonly individuals such as a company’s chief operating officer, chief financial officer, and representatives of major shareholders will serve as inside directors.

Optimally a company would have a healthy balance of independent and inside directors to provide a diverse range of knowledge and viewpoints.

Advantages and Disadvantages of Independent Directors

independent director

Advantages of Appointing Independent Directors

Independent directors can offer many benefits to a company. These include:

  • Objective Assessments: Inside board members may have a difficult time providing an objective view of the strengths and weaknesses of the company and its competitors. An independent director has no preconceived biases that would prevent them from providing a neutral assessment.
  • A Fresh Perspective: Company insiders can easily become immersed in their company’s culture. This can result in biased decision making and make it easy to fall into a pattern of suboptimal decision making.
  • Unique and Specialized Skills: A company can bring on independent directors with unique knowledge, experience, and reputations for success. This can offer advantages in addition to their objectivity.
  • Neutral Decisionmakers: Often with company insiders personal biases and conflicts of interest can lead to conflict. This can be particularly harmful when it concerns succession planning. An independent director can provide a neutral voice to help settle conflicts and ensure that promising future leaders are not overlooked in planning who will move up the corporate ladder.

Disadvantages of Appointing Independent Directors

There are some disadvantages related to independent directors as well. These include:

  • A Lack of Information: Independent directors are naturally less well informed than a company’s management team. This can result in less effective decision making.
  • Potential for Bias Remains: Though the members of a board may be chosen for their lack of ties to the company, management may still be capable of influencing their decision making.
  • Expertise May Vary: Though a director may be independent of a company and free of influence that does not mean that they necessarily possess the skill and expertise needed to be a good fit for the board.

Example of the Importance of Independent Directors

In order to better understand why independent directors play a crucial role in corporate governance consider the collapse of the Enron corporation in the early 2000s.

An investigation by the U.S. Senate’s Committee on Governmental Affairs found that the independence of members of Enron’s Board of Directors had become compromised by financial ties between the company and certain members.

This included permitting the company’s auditor to serves as the outside auditor while also serving as a consultant and internal auditor for the company and permitting the company’s CFO to operate private equity funds with which the company performed business.

These actions contributed considerably to Enron’s eventual collapse.

This was one of the largest corporate bankruptcies in history and resulted in an enormous scandal that resulted in the passage of several laws to protect investors and a push to increase the number of independent directors sitting on the boards of large corporations.

Key Takeaways

  • Independent directors are members of a board of directors who do not have a medical interest in the company, are not a member of the executive team, and do not play a role in daily operations.
  • Multiple stock exchanges such as the NYSE and NASDAQ require that the majority of members of the board of directors of companies be independent as a condition of being listed.
  • Independent directors play a key role in maintaining good corporate governance through the objectivity they bring to a board. This helps to ensure that they will act in the best interests of shareholders and ensure accountability.

FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.

  1. Harvard Law School "What Exactly Is an Independent Director?" Page 1 . May 13, 2022

  2. Harvard Law School "Independent Directors and Controlling Shareholders" Page 1 . May 13, 2022