Independent Outside Director: What it is, How it Works

What Is an Independent Outside Director?

An independent outside director is a member of a company's board of directors (BoD) that the company brought in from outside (as opposed to an inside director chosen from within the organization).

Because independent outside directors haven't worked with the company for a period of time (typically for at least the previous year), they aren't existing managers and do not have ties to the company's current way of doing business. Independent outside directors can bring new insights and balance to a team; however, some downsides also exist (read on below).

Understanding Independent Outside Directors

The general consensus among stockholders is that independent directors improve the performance of a company through their objective view of the company's health and operations. At times independent outside directors can also bring specific expertise from their sector and/or personal experience. For example, a company specializing in health technologies might bring in an outside director with a prestigious medical background and degree to provide additional insight into the science behind their product(s).

An additional advantage of an independent outside director is that they do not have to worry about retaining their job within the company and can make their voices heard in a more objective manner (according to some). Stockholders and politicians pushed for more independent outside directors for large corporations in the wake of the Enron collapse in the early part of the 2000s. The consensus was that the lack of outside perspective and accountability masked many of the deep issues and false claims that were occurring and allowed to repeat within the company.

Independent Outside vs. Insider Director

A company should have a balance of both outside and inside directors. While outside directors can provide valuable and distinct perspectives, inside directors have the advantage of knowing the company’s inner workings, culture, history, and issues that need solving in real-time. Inside directors can be current employees, officers, or direct stakeholders in the company.

More specifically, they typically include a company's top executives, such as the chief operating officer (COO), the chief financial officer (CFO), and the chief operating officer (COO), and representatives of major shareholders and lenders, such as institutional investors with sizable investments in the company. In this case, the majority shareholder will often insist on appointing one or more representatives to the company's board of directors.

As with outside directors, inside directors still have a fiduciary duty to the company and are expected to always act in the company’s best interests.

Outside Directors and the Example of Enron's Failure

Outside directors have an important responsibility to uphold their positions with integrity and protect and help grow shareholder wealth. In the case of Enron (as mentioned above), many accused the company’s outside directors of being negligent in their oversight of Enron. In 2002, plaintiffs and Congress accused Enron's outside directors of allowing the company’s former CEO Andrew S. Fastow to enter into deals that created a significant conflict of interest with shareholders as he concocted a plan to make the company appear to be on solid financial footing, despite the fact that many of its subsidiaries were losing money.

As the Enron example showed, it’s important to set and support clear corporate governance policies to mitigate the risk of such fraud. Corporate governance is a comprehensive system of rules that control and direct a company. These protocols balance the interests of a company's many stakeholders, including shareholders, management, customers, suppliers, financiers, government, and the community. They also help a company attain its objectives, offering action plans and internal controls for performance measurement and corporate disclosure.