Corporate Governance: Why Independence Matters?

Published in 2016

Introduction & Overview

This report takes up the issue of corporate governance in modern business organisations and the role of independent directors in enhancing such corporate governance.

The significance of high-quality corporate governance is now being widely appreciated on account of several causes (Carter et al., 2003). Whilst the last few decades have witnessed an enormous expansion of national and global business activity, they have also been marked by the emergence of several corporate and financial scandals, especially in large and well-known business organisations (Carter et al., 2003). The collapse of Enron, a globally famous energy organisation, which resulted in considerable losses to organisational shareholders and employees, was found to have occurred primarily because of various risky and fraudulent actions by the organisation’s senior management (Carter et al., 2003). The Enron and WorldCom scandals in the late 1990s resulted in immense public and media debate and to the enactment of The Sarbanes Oxley Act in 2002, which specifically aimed to enhance corporate governance and make senior organisational executives accountable and even punishable for their acts of omission and commission (Carter et al., 2003).

It is essential to understand that modern-day corporations are dominant and powerful institutions that influence societies and economies (Bhagat & Jefferis, 2002). The enormous expansion of many of these organisations across the world have resulted in the reduction of their accountability to national regulatory systems and have in many ways made them all-powerful and subject only to self-governance (Bhagat & Jefferis, 2002). It is thus essential for such corporations to develop effective systems for their governance and to ensure that their actions do not adversely affect the interests of numerous stakeholders and the environments in which they exist and function (Bhagat & Jefferis, 2002).

Corporations were in the past expected to focus primarily on the achievement of organisational profitability and accretion of shareholder wealth. Still, such public attitudes have changed radically in the past years (Becht et al., 2003). Whilst it is accepted that modern-day corporations will continue to have profit and wealth oriented objectives, it is now being increasingly felt that such organisations should work actively for the benefit of all stakeholders and the communities in which they exist (Becht et al., 2003). Such alterations in the objectives of organisational working have resulted in increasing demand for high-quality corporate governance (Becht et al., 2003). With modern-day companies being headed by directorial boards, such boards are supposed to be primarily responsible for implementing corporate governance (Becht et al., 2003). Several experts have argued that such committees must comprise individuals of high levels of integrity and probity and function with independence if corporate governance levels have to be enhanced substantially (Becht et al., 2003).

This report examines the area of corporate governance, with particular regard to the role of directorial independence. It assesses the relationship between such independence and corporate performance and attempts to provide suitable suggestions for the enhancement of board independence in order to improve corporate governance levels.

Corporate Governance and Boards

Whilst a broad definition of corporate governance is yet to emerge, it can broadly be described as the combination of systems, processes and structures used for controlling organisations (Raheja, 2005). It comprises various rules that govern relationships between organisational boards, shareholders, corporate managements and stakeholders (Raheja, 2005).

Corporate governance theory has evolved over the years; whilst it was in the past explained by the stewardship theory, it is now being increasingly defined by the stakeholder theory (Xie et al., 2003). The stewardship theory, which is grounded in sociology and psychology, concerns the safeguarding and maximisation of shareholder wealth through the agency of stewards, namely organisational managements (Xie et al., 2003). The stakeholder theory, which emerged in the 1970s and was developed by Freeman in 1984, on the other hand, concerns a governance model that makes corporations accountable, not just to shareholders but to a wider range of stakeholders (Donaldson & Preston, 1995). Corporate governance, as per the stakeholder theory, should ensure that organisations work for the benefit of diverse stakeholder groups and not subjugate ethics and fairness to economic profitability and maximisation of shareholder wealth (Xie et al., 2003).

Such organisational or corporate governance, which aims to ensure integrity, honesty, transparency and fairness in organisational working, is the primary responsibility of the board of directors, who form the apex of all contemporary corporate structures (Malcolm & Gompers, 2003). The board of directors of modern corporations comprise of individuals who are responsible for organisational wellbeing (Kose & Senbet, 1998). Such responsibilities are essentially very broad in nature and comprise of numerous functions and responsibilities (Kose & Senbet, 1998).

Directors act in the first place as trustees and have a number of fiduciary responsibilities (Hermalin, 2005). Such fiduciary responsibilities entail the safeguarding and protection of organisational assets, the ensuring of compliance with all legal and regulatory requirements, and most importantly, the protection of the rights and benefits of all stakeholder groups (Hermalin, 2005). Modern directorial boards are thus not just responsible for the accomplishment of organisational strategies and objectives but also for the protection of all stakeholder groups (Fields & Keys, 2003).

It is their responsibility in such circumstances to ensure that the organisations in which they function specifically do not engage in any type of illegal or unethical activity that can compromise the wealth of their shareholders and cause losses to other individuals and entities (Ponnu & Karthigeyan, 2010). The members of directorial boards have extensive responsibilities that are laid down by company law as well as organisational policies (Ponnu & Karthigeyan, 2010). Directors must meet at regular intervals in order to assess organisational operations and performance and participate in important decisions about organisational decisions that need to be taken at the top most level (Ponnu & Karthigeyan, 2010). They are called upon to exercise independent judgement in decision making and ensure that their decisions are fair, transparent, ethical and honest (Linck et al., 2008). They must take care to ensure that their organisations do not adopt unfair or partisan policies towards employees and that all organisational policies are implemented with fairness and transparency (Linck et al., 2008). They should furthermore take care to ensure the absence of any sort of conflict of interest between their personal objectives and those of the corporations in which they function (Linck et al., 2008).

The law in the United Kingdom clearly specifies that directors of limited companies should use their skills, judgement and experience in order to enhance the profitability and success of their organisations (Boone et al., 2007). They should adhere to corporate rules and regulations, as detailed in the organisation’s memorandum and articles of association, and ensure that their decisions are made for organisational and not for personal benefit (Boone et al., 2007). They should take care to inform all shareholders if there are chances of their obtaining personal benefits from corporate transactions (Becht et al., 2003). They are also responsible for ensuring proper maintenance of organisational records and should take care to report any alterations in records to regulatory bodies like the Companies House and HM Revenue and Customs (Becht et al., 2003). They should also strive to ensure that organisational financial statements provide a true and fair view of organisational performance and circumstances (Becht et al., 2003).

Members of the board should be aware of their personal responsibilities in areas of statute on account of their positions as corporate directors (Hermalin, 2005). It should also be kept in mind that the companies in which they serve are specific legal entities and are subject to diverse statutory obligations (Hermalin, 2005). Corporate directors, in their capacity as trustees and agents, thus also have responsibilities to ensure organisational compliance with such statutory requirements (Carter et al., 2003).

It is important to note that the UK Company’s Act 2006 has laid down, for the first time, some specific directorial duties (Legislation.gov.uk, 2010). These duties are common law and equitable in nature and comprise of the following:

1. Directors of UK limited companies should function within the powers that have been detailed by the constitutions of their companies and use such powers solely for the reasons and purposes for which they have been conferred.
2. Directors should make all efforts to promote organisational success for the benefit of its members. The law in this case does not specify shareholders and presumably includes employees and stakeholders.
3. Directors are clearly responsible for exercising independent judgement and should thus refrain from being influenced by other external or internal forces (Legislation.gov.uk, 2010).
4. Directors are expected to make use of reasonable care, skill and diligence in the fulfilment of their responsibilities.
5. They should ensure avoidance of all types of conflicts of interests.
6. They should take care to refuse benefits of diverse types from third parties.
7. They should take care to declare their interests, if any, in all proposed or existing transactions or arrangements (Legislation.gov.uk, 2010).

It is important to note that directors can become liable for penal action if their organisations fail in carrying out their statutory obligations (Legislation.gov.uk, 2010). They can however state in their defence, in case of such developments that they had reason to believe that such responsibilities were given to specific and competent persons (Legislation.gov.uk, 2010). Members of directorial boards are very importantly responsible for the preparation of accounts and reports of the board of directors (Legislation.gov.uk, 2010). Directors should ensure that companies maintain comprehensive and accurate accounting records of all transactions, prepare financial statements for all financial periods, present them to shareholders and file them with appropriate regulatory authorities (Legislation.gov.uk, 2010).

It is clearly evident from the above discussion that directors of corporate boards in the UK function as agents and trustees and have multifarious and complex responsibilities that essentially aim at achieving high levels of corporate governance. Whilst there is little doubt that the majority of such directors apply themselves conscientiously and sincerely towards the fulfilling of their obligations, the continuance of corporate scams, misdemeanours and scandals implies that significant improvement needs to occur in this area (Hermalin, 2005).

Research in the reasons for the collapse of Lehman Brothers in 2008 have revealed that the CEO of the organisation pressurised the board of directors and obtained the acquiescence of the members of the board for organisational engagement in extremely risky business practices, as also in increasing the leverage of the company to unacceptably high levels (Fox, 2009). The failure of the directors to act independently and in the interest of the organisation was perceived to be an important cause for its financial collapse and ultimate closure (Fox, 2009).

Importance of Independence of Board Directors for Ensuring of High Quality Corporate Governance

The example of Lehman Brothers detailed in the previous section vividly outlines the ways in which members of the board of directors of large corporations can be pressurised to act in ways that may be against the interests of diverse stakeholders (Fox, 2009). Whilst the CEO of Lehman might have been convinced of the correctness of his business strategy, it was the duty of the board members to have studied the various merits and demerits of such a course of action, clearly brought out its several risks, and strongly objected to its adoption (Fox, 2009). Directors of limited companies, as evident from the analysis carried out in the previous section, have various responsibilities towards corporate governance, and it is clear that such duties cannot really be exercised without complete independence of thought and action (Warther, 1998). It is also unlikely for directors with executive positions and responsibilities to always act with absolute independence and in opposition and contradiction of adopted organisational strategies, unless and until they are clearly illegal and against the interests of diverse stakeholders (Warther, 1998). Numerous small and large infringements of corporate governance are likely to be overlooked by such executive directors in the pursuit of their organisational strategies (Warther, 1998).

Modern-day companies thus have a number of independent board directors whose appointments are approved by organisational shareholders (Xie et al., 2003). Such directors are by and large chosen for their demonstrated skills and expertise and are inducted into boards on account of their ability to provide appropriate and high quality counsel and guidance to organisational managements (Xie et al., 2003). Independent directors, whilst provided with some nominal financial remuneration for their services to the board, do not avail of any other financial benefits, directly through salaries, or indirectly through diverse types of assignments or business dealings (Raheja, 2005). Such absence of financial remuneration, experts feel, should make them far more independent in their assessment of organisational affairs than the CEOs or paid directors of such organisations and lead them to ensure that organisational strategies, policies and processes do not run counter to the principles of corporate governance (Raheja, 2005).

Experts like Linck et al, (2008), however, state that informal networks develop over time in most industrial sectors, which in turn results in the reduction of such independence of appointed independent directors. Some shareholders are thus asking for independent directors to be appointed from outside the industry in order to enhance their levels of independence. Independent directors very clearly have special positions in the governance structures of business corporations because of their lack of allegiance to major shareholders or to the organisational managements (Linck et al., 2008).

Such directors, because of their financial and operational independence, should be able to engage in objective assessment and judgement in various areas. The Corporate Governance Committee, (2001), has suggested that independent directors can specifically contribute in areas like (a) succession planning, (b) executive remuneration, (c) change in corporate control, (d) internal and external audit and 9e) evaluation of organisational performance. A number of experts have at various times elaborated upon the need for independent directors to engage themselves more effectively in the affairs of their organisations in order to improve levels of corporate governance (Koerniadi & Tourani-Rad, 2012). Such directors should possess independent mindsets, have balanced perspectives, and be ready to object to management proposals, if they feel such objection to be necessary for organisational benefit and protection of rights of various stakeholders, including minority shareholders (Koerniadi & Tourani-Rad, 2012).

Relationship between Board Independence and Organisational Performance

Extensive research has been conducted across the world on the impact of independent directors on organisational performance (Hermalin, 2005). Many experts have explained that the presence of independent directors can not only help in the provisioning of high quality counsel and guidance but should also specifically help organisations in refraining from engaging in risky, unsustainable or illegal business practices (Hermalin, 2005). The presence of such directors on organisational boards should lead to significant enhancement on overall organisational performance (Hermalin, 2005). Their presence should furthermore help corporations to improve their internal control and audit functions and thereby bring about greater operational efficiencies and productivity (Hermalin, 2005).

Actual empirical findings on the issue are however ambiguous and do not establish strong relationships between board independence and organisational performance. Koerniadi and Tourani (2012), studied the impact of board independence on firm performance and found that independent directors do not add to firm value, except when they are in the minority. They found that enhancing the numbers of independent directors did not really lead to any enhancement in corporate governance or in firm performance. Arosa, et al., (2010) researched relationships between independent directors and performance of Spanish firms and found a significant positive association between board independence and firm performance. Bhagat and Black (1999), on the other hand, found that a greater number of independent directors in firms could cause low profitability but were at the same time unable to prove that lesser numbers of independent directors could inversely lead to higher profitability.

Several other research findings, especially those of … are equally ambiguous on the relationship between board independence and organisational performance. Some studies reveal a positive association; some reveal a negative association and others do not find any association, both positive and negative between board independence and firm performance.

Conclusions and Recommendations

This paper attempts to study the role of independent directors in the enhancement of corporate governance and examine empirical findings on the relationships between higher board independence, as evidenced by the number of independent directors and board performance.

The examination and analysis of various information sources available on the subject clearly reveal that corporate governance continues to be a source of worry for organisational shareholders and other stakeholders in the contemporary business and social environment. Whilst the last few decades have been distinguished by tremendous enhancement of business activity, organisational profitability and shareholder wealth, they have also been marked by the occurrence of huge corporate scandals and scams, which have resulted in huge losses to shareholders, employees and other stakeholders.

Numerous investigations have also revealed that such scandals and scams have essentially stemmed from poor quality corporate governance and from the deliberate adoption of risky and unethical business strategies and processes (Palepu & Healy, 2003). The early 2000s witnessed the occurrence of huge financial scams in organisations like Enron, WorldCom and Parmalat, which involved high levels of fraud with the complicity and knowledge of the organisational management and the board of directors (Palepu & Healy, 2003). The financial and economic crisis of 2007-2010 was likewise caused by excessive risk-taking by the management of banks and financial institutions in the United States and other western countries (Gorton, 2008). Such excessive risk-taking resulted in the collapse of several banks and to the development of a global economic crisis (Gorton, 2008).

There is wide agreement amongst management academics and experts on the need for high levels of board independence for the achievement of improved levels of corporate governance (Fields & Keys, 2003). Such independence, experts assert, can be achieved by the induction of independent directors of proven ability and integrity on organisational boards (Fields & Keys, 2003). Such directors should be able to moderate management decisions and ensure that organisational strategies do not go against the requirements of law, regulations, sustainability and the interests of shareholders and other stakeholders (Fields & Keys, 2003).

Whilst empirical findings on the association of board independence with firm performance are ambiguous and contradictory, the association between greater board independence and corporate governance seems to be extremely reasonable and logical (Carter et al., 2003). Experts on the subject however opine that true independence in a closely networked environment is difficult to achieve and independent directors for this purpose should be chosen with great care, preferably from outside the industrial sector, in order to ensure their lack of involvement with organisational managements (Carter et al., 2003).

Such directors should moreover be chosen, as much for their skills and abilities, as for their record of independence and integrity (Carter et al., 2003). They should also be specifically inducted into critical committees like those responsible for organisational audit, succession planning, remuneration and strategy to ensure that they can contribute effectively to organisational governance (Carter et al., 2003).

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