Examining the importance of independent directors

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The current economic climate has created many unexpected challenges for family-owned businesses. In light of these challenges, many companies are looking for new ways to strengthen their businesses today in order to ensure their future viability.

We believe that family-owned businesses should consider adding an outside director(s) to their boards as one response to the uncertain economy.  Doing so is likely to promote progress through the implementation of new ideas, provide a layer of legal protection for business transactions, and protect the business by minimizing family conflict.

If properly selected, an outside director will bring a unique perspective to the board. Family-owned businesses often have boards made up of family members and "insiders" who largely have similar experiences and perspectives. An independent director may have different professional, educational or personal experiences that enable him or her to view an ongoing challenge differently than the rest of the board and, therefore, provide alternative solutions or strategies.

It may be particularly beneficial to have a fresh perspective if other directors have been closely involved with the business since its inception. An independent director will have the ability to suggest that the way things have always been done might not be in the best interests of the business going forward, and that the business must evolve in order to survive.

Independence also may allow a new director to push for changes that other directors could be reluctant to suggest. Family members on the board may fear upsetting other family members, especially older generations. Employees on the board may be reluctant to disagree with family members because their job is at stake. An independent director is free from these limitations.

Even if the outside director's strategy or plan is ultimately rejected by the rest of the board, the more diverse composition of the board will create an environment that encourages creative thinking. This type of creativity will promote progress and make a business more likely to successfully adapt to the changing economy.

In addition to generating new ideas, an independent director's participation in business transactions will provide a measure of legal protection for other members of the board. A transaction between a family-owned business and a family member is vulnerable to attack as a "related party transaction" and even if not legally vulnerable, may be viewed as "unfair" or "tainted" if it is not independently approved.

Because an independent director can presumably approve decisions without being influenced by family members, his or her approval likely indicates that the action is in the best interest of the business, distinct from family interests. This arms-length approval will potentially shield the board from liability arising from a claim alleging a breach of fiduciary duties in approving a "related party transaction" and will help the transaction to be viewed as legitimate.

Finally, an independent director can often minimize family conflict. As noted above, if the independent director approves a transaction between the business and a family member, this provides more legitimacy to the transaction and will reduce the risk that other family members will feel that one family member is being favored. This is particularly important where some family members are involved in the business and others are not.

In the event of family conflict, a good independent director will be of value. While no family expects to encounter divisions, family-owned businesses should be prepared for this possibility. An outside director may be able to craft solutions that benefit the long-term viability of the business. He or she may also be able to preserve family relationships by serving as an informal third-party mediator in resolving family disputes.

All of the benefits noted above assume that you choose the right independent director, so a company should carefully and thoughtfully select the person it asks to serve in this capacity. Most importantly, you should work to ensure that the new outside director is truly independent. This type of independence requires that the board member has no personal or professional relationship with the business or decision makers inside the company (e.g., officers, directors and shareholders).

Independence, however, should not be the only consideration. It is important to recognize that during the selection process, an owner, who is likely also a board member, may have a natural tendency to nominate a candidate whose point-of-view and experiences are similar to his or her own.

While potentially independent, these candidates may not bring the desired diversity of thought or experience to the board. In order to avoid this problem, the company should seek to assemble a broad and diverse pool of potential candidates and place a premium on candidates with different perspectives (e.g., from a different industry, different life experiences, etc.). You might also consider appointing a third party to assist with selecting the outside board member or solicit suggestions from your current professional advisors.

Finally, it is critical that the outside director be someone who is willing to speak his or her mind and respectfully challenge management. Even a director with great and unique ideas is of limited value if he or she is unwilling to share these ideas openly or is easily intimidated by other board members.

Although privately held and family-owned businesses are not legally required to include independent directors on their boards, we believe that these businesses will often benefit from doing so. A family business should at least consider adding an outside director(s) to its board as part of an effort to provide for the best interests of the company. 

Peter G. Roth is a partner in the Business Law Group at Varnum LLP. Sarah Baumgartner is a Juris Doctor expected 2012 from University of Michigan Law School.

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