2.3 Independence in fact, appearance and form

After the composition/structure building block in the previous section, this section addresses the person building block of independence. According to section 13.1 of Recommendation 2005/162/EC of the European Commission, a supervisor is considered to be independent when ‘he is free of any business, family or other relationship, with the company, its controlling shareholder or the management of either, that creates a conflict of interest such as to impair his judgement’ (European Commission 2005: 56). The European Commission provides in section 13.2 some guidance by listing ‘a number of situations reflecting the relationships or circumstances usually recognised as likely to generate material conflicts of interests’. These situations are included in chapter 6 of this study that describes the Recommendation. In section 13.2 of the Recommendation it is added that the (supervisory) board itself should determine whether a supervisor is independent or not and that the list should not be considered to be binding. It is possible in this respect that none of the relationships or circumstances offered apply to a supervisor, but that he cannot be considered to be independent due to other reasons or circumstances. An example of such a circumstance is supervisor E with a life partner he is not married to and with whom he has three children. His life partner has a significant business relationship with the company. As there is no marriage, the life partner is not considered to be close family, but due to their close relationship the supervisor cannot work independently. The opposite may also apply. An example of such a situation is supervisor A whose brother works in the company’s restaurant. Due to the employment of his brother at the company, the supervisor cannot be considered to be independent according to the list of independence criteria. However, the supervisor can work independently, because his brother has absolutely no involvement in the management of the company. In these two cases, the European Commission allows the (supervisory) board to consider the particular supervisors to be non-independent and independent respectively.

The above-mentioned examples are quite clear and the (supervisory) board would probably have few problems in making the assessment. But in some situations the character of the relationship between the supervisor and the management of the company or the company itself is more subtle. An example is a supervisor whose child is a classmate and best friend of one of the children of the CEO of the company. Such a subtle relationship makes the assessment as to whether a supervisor is independent even more complex.

In the Annex of the Recommendation it is stated that assessment of independence ‘should be based on substance rather than form’ (European Commission 2005: 63). How to determine the independence based on substance is not worked out further by the European Commission. However, a distinction comparable to the difference between substance and form is also made in literature on the independence of auditors, which can be used in the assessment of director independence. In auditing literature it is called independence in appearance and independence in fact (Dopuch et al. 2003: 84-85). An auditor who is independent in fact has an independent mindset when executing his tasks, which will result in unbiased work. Independence in appearance means that the auditor appears to be independent. However, this might not be so in reality. Dopuch et al. cite the SEC to obtain a better understanding of the difference between independence in fact and independence in appearance and its consequences for the actions: ‘an auditor’s independence is impaired either when the accountant is not independent in fact, or when in light of all relevant facts and circumstances, a reasonable investor would conclude that the auditor would not be capable of acting without bias’ (SEC 2000). The European Commission stated in a Recommendation on Statutory Auditor’s Independence (2002/590/EC) that independence should address both ‘independence in mind’ and ‘independence in appearance’ (European Commission 2002: 34). Independence in mind requires a ‘state of mind which has regard to all considerations relevant to the task in hand, but no others’, and independence in appearance means ‘the avoidance of facts and circumstances which are so significant that a reasonable and informed third party would question the Statutory Auditor’s ability to act objectively’. The definition of independence in mind of the European Commission has the same meaning as the definition of independence in fact of the SEC. Therefore, the latter term is used in the remainder of this study.

Independence in fact , independence in appearance and independence in form must be considered together in order to obtain a better understanding of the differences. Although the terms described above are focused on auditors, they are useful for describing the independence of supervisors. Independence in fact entails having an independent mindset when executing tasks, which results in unbiased work of the supervisor. Independence in appearance entails avoiding facts and circumstances that are so significant that a reasonable and informed third party would question the supervisor’s independence. Independence in form entails compliance with the relevant independence criteria. This means that none of the relationships or circumstances in the list of independence criteria apply to a supervisor. Independence in form and in appearance might coincide in a number of cases, because the independence criteria are based on relationships and circumstances that are considered by the public to have a negative influence on independence.

Figure 2-2: The relationship between independence in fact, in appearance and in form. The main picture shows three overlapping types of independence: in fact, in appearance and in form. The small left picture shows a situation in which independence in form is able to capture a large part of independence in fact. The small right picture shows a situation in which independence in fact, in appearance and in form fully overlap each other.

The terms are interrelated and the relationships are given in the main diagram in Figure 2-2. In this diagram five supervisors – A, B, C, D and E – are shown. Their characteristics are described to obtain a better understanding of the differences. The example of supervisor A, whose brother works in the company’s restaurant, has already been described in this section. He is independent in fact and in appearance, because he has an independent mindset and he works without any bias – i.e. independent in fact – and is perceived to be independent by others – i.e. independent in appearance. However, according to the independence criteria he is not independent. He is therefore located in the light grey area instead of the dark grey area in the diagram, which represents supervisors that are independent in fact, in appearance as well as independent in form. Supervisor B is located in that dark grey area, because he works independently (independent in fact), he is perceived to be independent (independent in appearance), and is also independent according to the independence criteria (independent in form).

Supervisor C is only independent in fact. Supervisor C is, for example, a former executive director of the company who has no business, financial or family relationship with the current executive directors and no longer has any emotional ties with the company. However, due to his prior position as executive director, neither a reasonable third party would consider him to be independent (in appearance) nor would the corporate governance code consider him to be independent (in form). Supervisor D is at the other side of the diagram. Supervisor D, for example, has a long tenure on the board of the company as NED and a hidden agenda of which nobody has any knowledge. Due to his behaviour, a reasonable investor would consider him to be independent and not regard the long tenure to be an impediment for his independent supervision. The investor would qualify the supervisor as independent (in appearance), because he is not aware of the hidden agenda. Due to the hidden agenda, the supervisor is not independent in fact and the long tenure disqualifies him from being independent in form. It must be noted that not all corporate governance codes have included a tenure that exceeds a certain length as an independence criterion.

Finally, supervisor E is independent in form, but not in fact and in appearance. The example of supervisor E, whose unmarried life partner has a business relationship with the company, has already been described in this section. Due to the business of his life partner, supervisor E is not independent in fact and a reasonable investor would not consider him to be independent (in appearance). However, as he is not married, he is independent (in form) according to the corporate governance code.

If the list of independence criteria is well suited to capture independence in fact, the circle of independence in form moves in the direction of the circle of independence in fact. This movement is visualised in the small left hand diagram of Figure 2-2. In an ideal situation there is full overlap between independence in fact and in appearance, where independence in form is able to capture that completely. This situation is visualised in the small right hand diagram with three overlapping circles.

In the remainder of this study, the terms independence in fact, in appearance and in form are used. When a percentage of board independence is mentioned, independence in form is mostly reported, because this is the only measurable percentage of independence. Independence depends on board structure as well. Therefore, the next section gives an overview of different board structures and how independence is measured in these board structures.