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Michigan's Independent Director

By Cyril Moscow,* Margo Rogers Lesser,** and Stephen H. Schulman**

Recent amendments to the Michigan Business Corporation Act introduce the

concept of an independent director into the statutory scheme.'
The voluntary designation of directors meeting specified standards as "inde-
pendent" will give Michigan corporations the capacity to improve the function-
ing of the board of directors. If the novel concept proves useful in Michigan,
similar initiatives can be expected in other jurisdictions. The purpose of this
article, which will begin with an overview of the provisions and goals and then
examine the details and likely operation of the law, is to bring to the attention of
the corporate bar and the drafters of state corporate statutes this new and, we
believe, promising approach. 2

BACKGROUND
Much of the vast literature on corporate governance laments the separation of
ownership from control, the domination of the board of directors by manage-
ment, and the ineffectiveness of shareholder litigation as a mechanism for
policing corporate action and managerial self-dealing. Many proposals have
been made for improving the structure and strengthening the functioning of the
board of directors. From 1972 to 1981, the Securities and Exchange Commis-
sion made corporate governance a primary concern. Since 1982, the American
Law Institute has attempted to articulate principles of corporate governance.
Despite this attention over at least the last two decades, no significant action
(with the possible exception of audit committee requirements) has been taken to
strengthen board procedures or composition. The Michigan changes are a first
step toward this fundamental reform.
*Mr. Moscow is a member of the Michigan bar and practices law with Honigman Miller Schwartz
and Cohn in Detroit, Michigan. He is Chairman of the Business Corporation Act Subcommittee of
the Michigan State bar.
**Ms. Lesser and Mr. Schulman serve as Co-Reporters to the Business Corporation Act Subcom-
mittee. Ms. Lesser is a member of the Michigan and District of Columbia bars, former assistant
professor of law at Wayne State University Law School, and Associate Editor of the International
Society of Barristers Quarterly. Mr. Schulman is a member of the Michigan and New York bars
and professor of law at Wayne State University Law School.
1. 1989 Mich. Pub. Acts 121, effective Oct. 1, 1989.
2. The statutory proposal is derived in part from Moscow, The Independent Director, 28 Bus.
Law. 9 (1972).

57
58 The Business Lawyer; Vol. 46, November 1990

The Michigan Business Corporation Act was adopted in 1972 as a result of a

general revision effort directed toward making the Michigan Act a modern,
enabling statute. It included provisions from several states as well as prior
Michigan law. Since 1973, amending acts have made technical changes and
incorporated provisions that had become prominent nationally, such as limita-
tions on director liability and anti-takeover chapters, but these changes have
been piecemeal. In 1985, a subcommittee of the Business Law Section of the
Michigan bar began a general review of the statute to determine whether more
comprehensive changes were desirable. As part of the effort, proposals were
developed for clarification of various director-related problem areas, including
interested director transactions and dismissal of derivative suits.
In reviewing its amendment proposals, the subcommittee recognized that
there still was no method for dealing with abuse of the corporate process short of
wasteful and clumsy shareholder litigation which usually arises after harm is
done. In response to this perceived lack of a control mechanism within the
corporate structure, the subcommittee developed the version of the independent
director contained in the recently adopted legislation.

OVERVIEW OF THE STATUTORY CHANGE

Under the statute, a corporation, acting through either its board or its
shareholders, may designate as an independent director any director who is
elected by the shareholders and meets certain qualifications. The criteria for
qualification address both competence and independence. For corporations with
publicly traded securities, competence requires a minimum of five years' experi-
ence as a senior executive or director of, or attorney for, a corporation with
securities registered under the Securities Exchange Act of 1934, or equivalent
experience. Independence requires the absence of any disqualifying relationship
with the corporation for a three-year period prior to designation and a limita-
tion of the director's term to three years.
Once designated, an independent director has rights beyond those available to
other board members. Such a director is entitled to reasonable compensation in
addition to compensation paid to directors generally, as determined by the board
or shareholders; corporate funds are made available for expenses reasonably
related to the performance of the independent director's duties; and quite
significantly, the director may communicate with shareholders at corporate
expense, in any communication or report sent by the corporation to sharehold-
ers.
Beyond establishing the position of independent director and granting the
described rights to such a director, the statute accords express recognition to the
role of the independent director in three areas of corporate action. This director
may make determinations related to indemnification; may ratify corporate
transactions with directors or officers; and may determine that derivative litiga-
tion is not in the corporation's best interests. The authority of the independent
 Michigan's Independent Director 59

director in these three areas constitutes the key statutory inducement for
corporations to name one or more independent directors.
The immediate goals of the provisions are to stimulate a more inquiring
boardroom atmosphere and to forestall transactions that appear to be tainted by
managerial self-interest-transactions that are likely to lead to lawsuits. In
other words, the statute is structured to permit and encourage the independent
director to be an effective monitor of management, particularly in the area of
managerial integrity. More generally, the independent director is intended to
represent the corporation as a business enterprise and evaluate proposals in
light of the corporation's best interests. As a result, deliberations will include a
representative of the corporation itself instead of only managers and shareholder
groups who may not always have the business enterprise as their primary
concern.

DEFINITION AND EXPLICATION

The amendment adds the following definition to the statute:

"Independent director" means a director who meets all of the following

requirements:
(a) Is elected by the shareholders.
(b) Is designated as an independent director by the board or the
shareholders.
(c) Has at least [five] years of business, legal, or financial experi-
ence, or other equivalent experience. For a corporation with securities
registered under section 12 of the Securities Exchange Act of 1934 ...
"experience" shall mean experience as a senior executive, director, or
attorney, or other equivalent experience, for a corporation with regis-
tered securities.
(d) Is not and during the [three] years prior to being designated as
an independent director has not been any of the following:
(i) An officer or employee of the corporation or any affiliate of
the corporation.
(ii) Engaged in any business transaction for profit or series of
transactions for profit, including banking, legal, or consulting
services, involving more than $10,000.00 with the corporation or
any affiliate of the corporation.
(iii) An affiliate, executive officer, general partner, or member
of the immediate family of any person that had the status or
engaged in a transaction described in subparagraph (i) or (ii).
(e) Does not propose to enter into a relationship or transaction
described in subdivision (d)(i) through (iii).
60 The Business Lawyer; Vol. 46, November 1990

(f) Does not have an aggregate of more than [three] years of service
as a director of the corporation, whether or not as an independent
director.'

The considerations behind each element of the definition can be summarized

as follows:

1. [a] The director must be elected by the shareholders. Without that

requirement, the board could designate as independent a director that the
board chose to fill a vacancy, which would lead, in practice, to a lack of
independence. Although the subcommittee recognized that only nominees
acceptable to management are likely to be presented for shareholder
election, it was felt that the experiment had to begin within the usual
shareholder election format. It is possible that, with experience, state
legislatures or federal regulators eventually will require that independent
director selections be made from an approved listing.
2. [b] The statute allows either the shareholders or the board to make
the independent director designation. Shareholder action often is cumber-
some and slow, particularly in corporations subject to the federal proxy
rules. To provide sufficient flexibility to meet corporate needs, the defini-
tion allows board designation. Shareholders could revoke a board designa-
tion through their removal power. Directors may revoke their own desig-
nations by resolution.
3. [c] Proper functioning as an independent director requires compe-
tence. The definition contains an arbitrary objective standard of compe-
tence: [five] years of business, legal, or financial experience, or its equiva-
lent. It is expected that courts will examine the background of individual
independent directors when determining how much weight to give to their
determinations. For this reason, the statute does not attempt to list disqual-
ifying factors such as bankruptcy or securities law violations. Eventually
some certifying mechanism with more refined standards may develop, or
experience might lead to the codification of more useful criteria.
The specific attention given to publicly held companies, in the require-
ment that an independent director of a corporation having a class of
securities registered under the Exchange Act must have experience with
such a corporation, indicates the direction of the amendment. Although the
independent director device may sometimes be useful in the close corpora-
tion context, the situations which prompt the need for this change in board
composition arise most often in corporations whose securities are publicly
traded. The phrase "equivalent experience" should provide enough flexi-
bility to allow the selection of qualified securities professionals or academ-
ics, and with respect to smaller corporations, of persons whose experience
is adequate to fulfill the function under the circumstances. Initially, the
determination of equivalent experience is to be made by the designating

3. Mich. Comp. Laws Ann. § 450.1107(3) (West 1990).

 Michigan's Independent Director 61

body, either the shareholders or directors, and in a court challenge, the

court should defer to that body's determination unless the plaintiff estab-
lishes the contrary.
4. [d & e] Standards of independence were devised based on a three-
year absence of disqualifying relationships. The tests exclude officers and
employees, substantial suppliers and consultants, and their affiliates and
immediate family members from independent status. Again, some elements
of the definition are arbitrary, and other formulations of independence may
emerge. The proposed tests, however, are fairly strict and do serve to
distinguish the independent director from traditional "outside directors,"
who often are bankers, lawyers,,and consultants having business relations
with the corporation that may make truly independent action impractical.
5. [f] The requirement that an independent director cannot serve as a
director for more than three years is the most restrictive and unusual part
of the definitional test. Commentators frequently question the objectivity of
outside director consideration of management proposals because of the
collegiality that follows from the selection process and the working rela-
tionship among board members. This suggests the need for a time limit on
the independent director's position. On the other hand, independent direc-
tors may be difficult to locate and must have familiarity with the corpora-
tion if they are to perform their functions. This suggests a contradictory
need for some substantial length of service. The subcommittee selected a
three-year limitation as a balance between the bias that can develop and
the need for experience. The three-year test refers to total time as a
director and need not be continuous or recent. Once an independent
director reaches the three-year limit, his independent status terminates
although nothing in the statute prevents him from remaining on the board
as an ordinary director.

STATUTORY RECOGNITION
The statute refers to action by independent directors in three contexts. In
revising the treatment of interested director transactions, substantially along the
lines of Model Act section 8.31, the subcommittee included approval by all
disinterested independent directors as one alternative method of authorization."
Although the statute lists independent director approval among several possible
procedures without explicitly giving it special effect, a plaintiff might well find
it more difficult to challenge an interested director transaction that was autho-
rized by a corporation's independent director. Where the statute both creates a
position defined to be independent and assigns a specific role to a director in that
position, a court might conclude that independent director action merits greater
deference than approval by other directors.

4. Id. § 450.1545a(2).
62 The Business Lawyer; Vol. 46, November 1990

Another express reference to independent director action appears in the

indemnification provisions. The Michigan Act allows indemnification of various
persons if statutory standards of conduct are met. The amendment adds that the
determination of whether the statutory standards are met may be made by "all
independent directors who are not parties or threatened to be made parties to
the action, suit, or proceeding."' As is true with the approval of interested
director transactions, an indemnification decision by an independent director is
not accorded special statutory effect but, for the reasons discussed above, may be
less vulnerable to challenge than a decision by others who are statutorily
authorized to act but who are not defined as "independent."
The third and most important context for statutory recognition of indepen-
dent director action concerns derivative suits. The subcommittee attempted a
rethinking of the treatment of shareholder derivative actions and based its
revisions on proposals for the Model Act. Accordingly, several changes, such as
a universal demand requirement after which suit may be filed, are designed to
eliminate the present focus on procedural technicalities, and the court is given a
standard for considering a corporate motion to dismiss. A determination by all
disinterested independent directors that a derivative action is not in the best
interests of the corporation is one of the listed bases for such a corporate motion
and is expressly given special weight. The section provides:

Section 495. (1) The court shall dismiss a derivative proceeding if, on
motion by the corporation, the court finds that [one] of the groups specified
in subsection (2) has made a determination in good faith after conducting a
reasonable investigation upon which its conclusions are based that the
maintenance of the derivative proceeding is not in the best interests of the
corporation. If the determination is made pursuant to subsection (2)(a) or
(b) [disinterested majority of board or committee], the corporation shall
have the burden of proving the good faith of the group making the
determination and the reasonableness of the investigation. If the determi-
nation is made pursuant to subsection (2)(c) or (d) [court appointed panel
or disinterested independent directors], the plaintiff shall have the burden
of proving that the determination was not made in good faith or that the
6
investigation was not reasonable.

Thus, if the independent directors (or the independent director, if the corpora-
tion has only one) make the determination, the burden is on the plaintiff to
show that they did not act in good faith or did not make a reasonable
investigation.
Since an independent director could be a party in the derivative litigation, the
statute has the additional requirement that the independent director be disinter-
ested. Section 491a defines disinterested person as "a person who is not a party
to a derivative proceeding, or a person who is a party if the corporation

5. Id. § 450.1564a(1)(d).
6. Id. § 450.1495(1).
 Michigan's Independent Director 63

demonstrates that the claim asserted against the person is frivolous or insubstan-
tial."' Under this definition, the inclusion of an independent director as a
nominal defendant, or mere participation by the independent director in ap-
proval of the challenged transaction, will not necessarily cause the independent
director to lose "disinterested" status for purposes of section 495. An indepen-
dent director accused of misappropriating corporate property, however, would
normally not be sufficiently disinterested to evaluate a derivative action brought
against himself.
Although the statute does not contemplate less than a full designation of an
independent director, a temporary appointment could be effectuated by a
designation when an independent director is needed (e.g., when a derivative suit
demand is made or an interested director transaction proposed) followed by a
separate termination when the work for which the independent director was
needed is completed. There may be some risk that a court would accord less
deference to the action of such a short-term or apparently single-purpose
independent director, in the event of later challenge.

COMPENSATION AND EXPENSES

In recognition of the special role and special burdens of independent direc-
tors, the statute expressly authorizes corporations to pay compensation to
independent directors beyond the compensation paid to other directors.' The
statute makes no attempt to set the amount of compensation, which will vary
with the size of the corporation and its general director compensation practices.
It is expected that independent director compensation ordinarily will be fixed by
the board in the same manner as compensation of other directors, and that
independent directors will not have a claim for special compensation beyond the
amounts authorized by the board. Compensation may also be set by sharehold-
ers.
In some situations, the independent director may need advice from counsel or
other advisors. The statute mandates the reimbursement of expenses reasonably
9
incurred by the independent director in the performance of duty.

REPORTS TO SHAREHOLDERS
To strengthen the influence of an independent director, the statute permits
the director to communicate directly with shareholders at the corporation's
expense in any report sent to shareholders by the corporation.o Michigan
corporations are required to send annual financial statements to shareholders, so
the independent director will have access to shareholders at least annually. If
the corporation is subject to the federal proxy rules, the independent director

7. Id. § 450.1491a(c).
8. Id. § 450.1505(3).
9. Id.
10. Id.
64 The Business Lawyer; Vol. 46, November 1990

will have access to the corporate proxy statement. The threat of public disclo-
sure of disagreements should enhance the ability of the independent director to
influence corporate action.

STANDARD OF CONDUCT
The independent director has no special obligations or liabilities under the
statute. The general standards of care and loyalty and statutory liabilities apply,
as will any articles provision limiting directors' liability for negligence. (In
1987, the Michigan Act was amended to follow the Delaware approach in
allowing articles limitations on director liability.) With charter liability limita-
tions in place, an independent director should not be unduly concerned that
accepting the position will subject him to liability for negligent performance of
duty. Although an independent director will still face liability for breach of the
duty of loyalty, the statutory standards of independence will prevent many of
the relationships that would raise duty-of-loyalty questions.

CONSTITUENCY
Some proposals for special directors have been based on the view that
particular interest groups, such as employees, customers, members of the local
community, or the general public, should be represented on the board. The
independent director has no such outside constituency, nor even any particular
internal constituency. It is intended that the independent director act solely in
the best interests of the corporation, viewing the corporation (in the usual
situation) as an ongoing business enterprise. Free of the pressures that often
lead management to concentrate on the company's immediate performance in
the stock market and with his focus on the corporate business, the independent
director may question transactions that do not enhance the company's long-term
business prospects.

OPERATION
The presence and participation in meetings of a fresh and independent voice
should sharpen the performance of many boards of directors and prevent some
corporate misconduct and error. At the least, egregious cases of corporate abuse
will be limited, either because they will not be proposed for independent
director scrutiny or because the independent director will feel more free to
question and reject them.
These goals might be viewed as modest when compared with other indepen-
dent director theories and literature. For example, there is no expectation that
the provisions will drastically alter the manner in which corporations are
governed. Corporations that adopt the independent director concept will rarely
name more than one director to that position, so the composition of boards will
not be greatly changed. Nor are independent directors likely to make dramatic
 Michigan's Independent Director 65

changes in business operation or management efficiency. The "social responsi-

bility" of corporations is not intended to be affected by the appointment of an
independent director. There will be, however, a mechanism in place to review
transactions before injury occurs, which, in many situations, will be an improve-
ment over the prevailing reliance upon managers and courts for corporate
governance.
Since the Michigan Business Corporation Act applies to corporations ranging
from incorporated proprietorships to some of the nation's largest corporations,
the roles that independent directors will play necessarily will be varied. The
most effective application may be in a medium-sized, publicly traded corpora-
tion managed by a controlling shareholder where there is no tradition of outside
director influence. In such a situation, the questioning independent voice will
separate the corporation from the dominant shareholder and prevent the auto-
matic identification of the interests of the corporation with the personal desires
of the controlling shareholder.
The possibility that independent directors will be effective raises the issue of
whether corporations will voluntarily add them. The subcommittee believes that
the incentives built into the statute should be sufficient inducement, but there
might also be important advantages to corporations beyond the three statutorily-
recognized areas of independent director action. In other sensitive or controver-
sial situations, such as responses to takeover proposals or parent-subsidiary
transactions, objecting shareholders and courts might defer to the judgment of
an independent director. Surely a competent independent director is in a better
position to determine the value of a transaction to the corporation than is a court
in subsequent litigation. Bolstered by the statutory recognition of the indepen-
dent director, courts should feel less need to second guess corporate decision-
making.
Some of the anticipated effects of an independent director can be demon-
strated more concretely through a brief review of two leading recent cases
involving directors of large corporations. In Smith v. Van Gorkom," directors
were found grossly negligent under Delaware law for failing to carefully review
an acquisition proposal. If an independent director had been present during the
deliberations, that director might well have raised questions about the proposal
or asked for more time. Conversely, if an independent director had considered
the transaction to be so obviously proper that no further information or time
was needed, the Delaware Supreme Court might have been more willing to
defer to the judgment of that director and less inclined to substitute its own view
of the appropriate depth and duration of analysis.
In Edelman v. Fruehauf," a case governed by Michigan law, the Sixth
Circuit Court of Appeals found that the board had "rubber stamped" a
management buyout proposal without adequately considering alternatives. The
presence of an independent director could have improved the board's treatment

I1. 488 A.2d 858 (Del. 1985).

12. 798 F.2d 882 (6th Cir. 1986).
66 The Business Lawyer; Vol. 46, November 1990

of the management proposal. Perhaps a more careful and objective review

would have been made if an independent director had been involved. On the
other hand, if an independent director had approved the proposal, the court
might have viewed the transaction with less suspicion. In managerial buyouts as
well as similar difficult areas, approval by an independent director should be a
useful authorizing mechanism.
Of course, the independent director is not expected to solve all or even most of
the problems in corporation law, particularly in the complicated takeover area.
We submit, however, that if an independent director is involved in the decision-
making process, there should be less misconduct, less litigation, less reliance on
cosmetic procedural formalities, and less judicial probing into the nuances of
complex transactions.

FUTURE
If successful, the Michigan experiment will encourage additional develop-
ments in the strengthening of the board of directors." Regulatory authorities,
such as the Securities and Exchange Commission and the stock exchanges, may
seize upon the idea as a practical method of improving corporate governance
and mandate the addition of an independent director for larger corporations.
Insurance companies could make the presence of an independent director a
requirement for the maintenance of director and officer liability insurance.
Institutional investors could establish the presence of an independent director as
a prerequisite to investment in securities of a corporation. In this amendment,
state legislation leads the way toward more effective board monitoring of
corporate business affairs.

13. Independent Director Foundation, 2290 First National Building, Detroit, Michigan 48226,
was organized in 1990 to promote the concept and monitor developments. Ms. Lesser is executive
director of the Foundation.