Corporate Governance: Role, Independence and Impact on Company Performance

Introduction

This report aims to examine the area of corporate governance in modern-day business firms, with specific regard to the role of the independence of boards of directors of business corporations.

Corporate governance essentially concerns the optimisation of diverse systems of policies, processes, rules, and regulations used for directing and controlling the operations and functions of business organisations (Core et al., 1999). Whilst business corporations undoubtedly exist for the achievement of organisational profits and accretion of shareholder wealth, their operations and activities can affect the interests of several stakeholders (apart from shareholders), namely organisational employees, customers and vendors, banks and lenders, governments and regulatory organisations and of course the communities and the larger environment in which organisations work (Core et al., 1999).

Corporate governance entails the ensuring of the conduct of organisational activities in a fair, ethical and lawful manner, with due consideration given to the legitimate rights and demands of all stakeholders (Baysinger & Butler, 1985). Recent years have, however, seen the occurrence of several incidents of a corporate misdemeanour, scandals and scams, which have, in turn, led to immense debate and discussion on the progressive reduction in levels of corporate governance in modern-day firms (Baysinger & Butler, 1985).

The board of directors of business firms constitute the topmost hierarchical body in such organisations and are responsible for ensuring appropriate corporate governance (Ehikioya, 2009). The continuance of corporate scams, despite the enactment of the Sarbanes Oxley Act in the United States in 2002 and the development of a corporate code of conduct in the UK have raised doubts and apprehensions about the effectiveness of boards of directors in ensuring corporate governance (Ehikioya, 2009). The need to ensure the independence of such boards from pressure from organisational managements, especially from senior managers like Chief Executive Officers (CEOs), Chief Operating Officers (COOs) and Chief Financial Officers (CFOs), all of whom are often members of corporate boards, is being taken up for discussion at various forums (Johnson et al., 2000).

This report takes up the role of board independence in modern-day corporate governance and puts forward recommendations for the enhancement of such independence and corporate governance.

Role of Boards in Corporate Governance

Corporate governance, as elaborated earlier, concerns the policies, principles, processes and systems for the governance of companies (Kota & Tomar, 2010). These systems provide and detail the guidelines for organisational direction and control for the satisfaction of corporate objectives and benefiting of all stakeholders (Kota & Tomar, 2010). Corporate governance must importantly be based on principles of fairness, integrity and transparency in the conduct of business (Ibrahim & Samad, 2011). It must focus on (a) compliance with legal requirements, (b) the making of necessary disclosures, (c) responsibility and accountability towards all stakeholders, and (d) the conduct of business in an ethical manner (Ibrahim & Samad, 2011).

The bringing about of high levels of corporate governance involves the determination of relationships between organisational management, board members and stakeholders (Shleifer & Vishny, 1997). There is wide agreement among experts on the responsibility of the board of directors in ensuring high levels of corporate governance and in implementing the best of global practices in the area (Shleifer & Vishny, 1997). Organisational directors essentially act as agents and trustees with fiduciary responsibilities and have a wide range of duties and obligations to their companies, their shareholders, and all other stakeholders (Shleifer & Vishny, 1997).
Directors, as trustees, have fiduciary duties and are responsible and accountable for ensuring the protection of their organisations from risks of misappropriation, dishonesty and lack of ethics (Ghosh, 2006). They are required to ensure that organisational systems not only safeguard their firms from risks of theft and fraud but also prevent management from engaging in dishonest or illegal activities (Ghosh, 2006). Directors are also responsible for breaches or inadequacies in their diverse fiduciary duties (Ghosh, 2006). They can as such, be held to be personally liable for inadequacies in satisfaction of statutory obligations and for the torts to which they commit themselves (Ghosh, 2006).

Modern-day boards often ensure the appropriateness of the conduct of their fiduciary functions through the functioning organisational internal audit systems (Ibrahim & Samad, 2011). The internal audit system of a corporation is distinct from its statutory external audit, which is carried out by external auditors who are appointed by shareholders (Ibrahim & Samad, 2011). Internal auditors, on the other hand, are organisational employees who are responsible for ensuring the conduct of all organisational activities, encompassing all departments and functions, in adherence with articulated organisational missions and strategies (Ibrahim & Samad, 2011). Internal auditors ensure organisational protection from theft, fraud and misappropriation (Ibrahim & Samad, 2011). They ensure organisational compliance with all statutory rules and regulations and attempt to ensure the prevention of various types of inefficiencies and misdemeanours by organisational employees (Ibrahim & Samad, 2011). Internal auditors should report to the board of directors, rather than to the CEOs or CFOs of corporations in order to ensure high levels of corporate governance (Ibrahim & Samad, 2011).

Directors have to furthermore carry out their responsibilities with diligence, educate themselves about organisational mandates and operations, and make active and concerted efforts to participate in the making of informed decisions about organisational activities (Dahya et al., 2006). Directors have to, in this regard, ensure the following:

• Ensure regular meetings of the Board of Directors
• Attend meetings, whenever possible
• Obtain information about board decisions
• Exercise independent judgement during voting in corporate decisions
• Ensure accurate transcription of meetings in minutes
• Review the corporation’s financial affairs
• Be aware of all laws that affect their organisations (Dahya et al., 2006)

Directors are expected to be loyal to their companies. They are required to act in good faith and honesty, as also in the best interests of their firms (Baysinger & Butler, 1985). Such duties of loyalty call for high levels of good faith in the exercise of directorial powers, as also for honesty and integrity in approaches and actions (Baysinger & Butler, 1985). Directors must use their powers in the best interests of their corporations, avoid delegation to the extent possible, refrain from conflicts of interest, and disclose the truth of their dealings with corporations (Baysinger & Butler, 1985). Such duties of diligence, honesty and good faith have various implications. Directors should act in the interests of their organisations, rather than only in the interests of shareholders or organisational managements (Ehikioya, 2009). This may often place them in difficult situations and call upon them to make difficult decisions, including disagreeing with other board members and even resigning from their board positions (Ehikioya, 2009).

It is evident from the above discussion that directors of modern-day corporations have extensive and varied obligations, which constantly call upon them to act, not just for short term organisational profits, but in accordance with high levels of ethics, honesty and fair play (Ehikioya, 2009). The achievement of high levels of corporate governance is certainly not an easy task, especially in the neo-liberal, intensely competitive and global contemporary business environment (Ehikioya, 2009).

The recent collapse of a building in Bangladesh that housed several garment making units illustrates the complexity of corporate governance and the various challenges faced by corporate boards (The Huffington Post UK, 2013). Investigations following the collapse of the building (which resulted in the deaths of more than 1100 people), have revealed that a number of the housed units were making clothes under contract for well known western garment retailers, like for example Primark of the UK (The Huffington Post UK, 2013). The disaster in Bangladesh has once again highlighted the self-serving practices followed by western garment retailers in outsourcing cheap goods from contracted manufacturing facilities in developing countries, wherein garment production is carried out in difficult, oppressive, and dangerous conditions (The Huffington Post UK, 2013). There is little doubt that western corporate boards are unaware of the conditions in which such production takes place, as also the impossibility of carrying out such activities in their home locations. The persistence of such business practices illustrates the continuance of inadequate corporate governance in modern-day firms.

It is a matter of regret that such incidents of poor corporate governance continue to happen, despite the existence of organisational boards comprising of individuals of high calibre with excellent professional records (Ameer et al., 2011). A number of experts on corporate functioning have in this context opined that high levels of corporate governance can be achieved only through the establishment of independent directorial boards that refuse to be cowed down by pressure from CEOs or specific shareholder groups (Ameer et al., 2011). The next section takes up the analysis of the role of independent directors in corporate governance.

Independence of Corporate Boards

Corporate experts have time and again emphasised that high levels of corporate governance can be achieved only when directors of corporate boards are independent of various types of internal and external pressures that may run counter to the interests and benefits of their organisations (Ezzamel & Watson, 1993). It is not difficult to understand that organisational managements may often be swayed in their executive actions on account of diverse forces like competitive pressures, environmental conditions, cost constraints and even personal greed temptations, like for example, in the form of performance-linked bonuses (Core et al., 1999). The occurrence of the subprime crisis has been associated with the huge bonuses that were promised to bank managers against achievements of excessively high loan disbursal targets.

It is thus not unlikely for CEOs, senior managers and even powerful groups of shareholders to bring pressure upon directors to agree with their suggestions and their perspectives on the ways in which organisations should function (Shleifer & Vishny, 1997). It thus becomes extremely important for directors to be absolutely independent in their evaluation and analysis of organisational objectives, strategies and performance and to be able to make appropriate decisions (Shleifer & Vishny, 1997).

Such independence in the case of corporate directors allows them to be objective and to evaluate the wellbeing and performance of their organisations without being influenced by interested parties or by any type of conflict of interest (Byrd & Hickman, 1992). Independent directors do not, in the first place, accept any type of compensation for duties other than board services (Byrd & Hickman, 1992). They do not engage in other types of business relationships with the corporations they serve, by way of consultancy assignments, professional services or business dealings as customers, vendors or financiers (Byrd & Hickman, 1992). This allows them to prevent the development of conflict of interest or of financial or other obligations with their companies (Fernandes, 2005). Such separation of the financial interest and organisational responsibilities allows independent directors to act with commitment towards organisational interests, use their judgement and good sense, and ensure that their organisations are run ethically, legally and effectively (Fernandes, 2005).

Whilst there is wide agreement on the need for directorial independence in the achievement of high levels of corporate governance, the activities of independent directors have also been subjected to significant scepticism and critique (Claessens et al., 2000). Some experts, for example, feel that the majority of independent directors chosen to serve on organisational boards often have several other priorities and commitments that hinder them from providing detailed attention to their board-level responsibilities and commitments (Claessens et al., 2000). It has also been stated that the lack of financial benefits for these directors from their involvement in such organisations may hinder their commitment to organisational affairs, with consequently adverse impacts on their corporate contributions (Brickley et al., 1994).

Connor, (2010), stated that independent directors also have strong incentives to resign from organisational boards when they are needed most. A study on independent external directors, conducted from 1989 to 2004, found that:

“Affected firms have worse stock performance, worse accounting performance, a greater likelihood of an extreme negative return, a greater likelihood of a restatement, and a greater likelihood of being sued by their shareholders, following surprise outside director departures in difficult business circumstance” (Connor, 2010, p 1).

Experts feel that independent directors often do not wish to associate with companies that are not doing well because of their apprehensions about the impact of such associations on their reputations, and thus leave organisations whenever these firms face difficult conditions (Dahya et al., 2006). Such contradictory views about independent directors have in turn led to the conduct of extensive research on the impact of such directors on firm performance, a subject that is taken up in the next section.

Impact of Board Independence on Performance of Firms

Several efforts have been made to find empirical evidence on the impact of independent directors on organisational performance. Such studies have however led to diverse results. Byrd and Hickman, (1982), found that independent outside directors have helped in shareholder protection in circumstances involving agency problems. Baysinger and Butler, (1985), also found from their studies that greater numbers of independent directors on organisational boards resulted in better economic performance. A number of other studies have revealed the association of greater numbers of independent directors with lesser chances of financial reporting and fraud and better success in tender offer outcomes (Claessens et al., 2000). Brickley, et al., (1994), found independence of boards to be associated with higher firm profitability, whilst Bhagat and Black, (2002), have found that greater numbers of independent directors in boards result in higher stock market returns.

A number of research studies have however produced opposing results. Researchers like Baysinger and Butler, (1985), and Fernandes, (2005), have not been able to find any connection whatsoever between a number of independent directors and organisational performance. Yermack, (1996), and Core, et al., (1999), carried out extensive research on the subject but were unable to find any significant association between the independence of organisational boards and diverse parameters of organisational performance.

Some studies have actually found negative associations between the numbers of independent directors and organisational performance and value. Bhagat and Black, (2002), for example, stated that too many independent directors have been found to be associated with the development of bureaucratic structures and with delayed decision making, with consequently adverse impacts on organisational performance.

Empirical findings on the subject thus appear to be inconclusive, and there do not seem to be strong grounds for categorically stating that greater board independence will result in improved organisational performance (Fernandes, 2005). Whilst the concept of independent directors is essentially appealing and their importance for ensuring of corporate governance is based upon reasonable thought and judgement, actual empirical findings as of date present an ambiguous and confusing picture.

Conclusions and Recommendations

This report aimed to examine the importance of corporate governance in the contemporary economic environment, with specific regard to the role of independent directors. The study and investigation carried out for the purpose of this report reveals that corporate governance continues to be an area of concern and a matter of disquiet for contemporary society. Business activity has undoubtedly increased exponentially during the last few decades, but this period has also been marked by the occurrence of numerous scams, especially so in the western countries.

The scams at Enron and WorldCom resulted in the enactment of The Sarbanes Oxley Act in the United States and to the establishment of a detailed corporate code of conduct in the UK. The world nevertheless experienced a huge and disastrous global financial crisis in 2008 that was essentially caused by the greed-fuelled actions of American bankers and investment experts. BP’s Gulf of Mexico disaster in 2010, which resulted in loss of human lives and enormous ecological and environmental destruction, was clearly the result of surprisingly poor quality corporate governance in what is a huge and eminently profitable international business organisation with diverse systems and policies for corporate governance (Hart, 2010). The recent building collapse in Bangladesh also illustrates the lack of corporate governance in the western garment manufacturing sector (The Huffington Post, 2013).

With the level of corporate governance in contemporary organisations continuing to be a source of worry, several corporate and organisational experts have stated that corporate governance can improve only when boards become independent of diverse internal and external pressures and function specifically in line with ethics, integrity, transparency and commitment to organisational and stakeholder interest. Such assumptions about the beneficial impact of board independence on corporate performance are essentially based on the premise that committed and independent boards should be able to play important and effective roles in restricting organisational managements and powerful shareholder groups from adopting unethical or illegal needs to achieve short term profit, business or competitive objectives.

Such reasoning is however not substantiated by empirical findings on the issue, which are clearly ambiguous and even contradictory on the impact of board independence upon organisational profitability (Fernandes, 2005). Empirical evidence on the issue is clearly divided and available literature and experts appear to differ strongly on their findings about the beneficial impact of board independence upon firm performance (Fernandes, 2005).

Notwithstanding such findings, there appears to be little uncertainty about the benefits of greater board independence upon the degree of corporate governance. There is little doubt of the various forces and pressures that are faced by organisational managers and CEOs in the conduct of their business in contemporary times, and it is very possible that such pressures can influence them to act in ways that are detrimental to long term organisational and stakeholder interests. The appointment of truly independent and committed directors to corporate boards can go a long way in enhancing better quality in corporate governance.

Care must however be taken to ensure that such directors are selected with great care, not just with regard to their ability, ethics and independence, but also with regard to their commitment to function sincerely, effectively, and in the interests of their organisations. The appointment of directors, who are unable to give sufficient time to their responsibilities, will not only lead to insufficient contribution, but can also have adverse consequences for corporate governance. The selection of appropriate independent directors and the careful detailing of their responsibilities will be critical for the achievement of high quality corporate governance.

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