The Role of Non-Executive Directors for the Best Work of Corporation - Essay Example

Legal Principles of Corporate Governance Table of contents Corporate Governance Problem The Board of Directors and Changes in Regulations Concerning Board Structure all over the World : Independent non-executives of the board in recent regulations of Australia, the UK and the US. Separation of chairperson and chief executive officer positions The information quality for better corporate governance in regulations Nomination, Remuneration and Auditing Committees Changes Conclusion. Future Developments in Corporate Governance: Board Structure Focus. CORPORATE GOVERNANCE PROBLEM Increased role of the private sector and capital and the increased global competitions for long-term capital as well as 1997 Asian financial crisis, corporate scandals and accounting failures around the world increased concern towards the issues of corporate governance. Corporate governance is mainly concentrated on problem of a safety mechanism which ensures the interests of shareholders and the interests of the directors managing the company are aligned and observed. In fact it deals with the ways in which suppliers of finance to the corporations assure themselves of getting a return on their investment. (Shleifer & Vichny, 1996 p.750) The governance problem arises when managers’ or directors’ interests of maximizing their own wealth, power and prestige and shareholders’ interests of increasing the value shareholders’ equity collide. (Moldoveanu & Martin, 2001) This misalignment of interests was addressed by the agency theory developed in the West. The theory assumes that interests of managers and principles or owners are not aligned because of the separation of ownership and control and the only mechanism to safeguard shareholder’s interests is to implement appropriate governance structures. (Jensen and Meckling, 1976 p.320) The agency problem in the United States and the United Kingdom is between the management/board and outside diverse shareholders while in continental Europe and Japan and East Asian markets with their concentrated ownership structure the main conflict is between the major owners/directors and minority shareholders. (Ho, 2005 p.63) THE BOARD OF DIRECTORS AND CHANGES IN REGULATIONS CONCERNING BOARD STRUCTURE ALL OVER THE WORLD Corporate scandals such as notorious Enron, Tyco, WorldCom, Polly Peck, HIH Insurance, and OneTel suggested the need of changes in corporate governance regulations all over the world. As trust towards company insiders as well as to auditors, analysts or regulators was shattered, governments started to think over regulations which would prevent such unfair practices. As the board of directors represents the interests of shareholders and controls\supervises the management, its effective functioning is a strong corporate governance mechanism. This paper will focus on the role of non-executive directors for the best work of corporation and changes in regulations which happened to improve corporate governance structure during recent years. Independent non-executives of the board in recent regulations of Australia, the UK and the US. Both local and international corporate collapses suggested inadequate corporate governance systems. Different countries responded differently to there problems. The US responded with a new legislation - the Sarbanes-Oxley Act of 2002. The UK introduced a number of reports with more detailed and complicated recommendations. Corporate governance gaps in Australia were patched by a combination of legislative and non-legislative methods - the Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act, known as “CLERP 9,” ten Principles of Corporate Governance introduced by ASX’s Corporate Governance Council, Australia Corporation Act 2001 which set important ethical norms of directors’ behaviour. The first international guidelines OECD Principles of Corporate Governance published in 1999, served the sample for Australian Standards of 2003. The same principles serve the basis of the USA corporate governance followed by US Sarbanes Oxley of 2002 in a response to corporate scandals. However, unlike all OECD countries which work on ‘the comply or explain’ principle, the USA employs ‘comply or be punished’ Sarbanes Oxley principle. The Sarbanes-Oxley Act is not only a change in some accounting and accountability rules, but a complete overhaul in business practices of corporate America. It sets firm regulations for senior management. Failure to comply will result in 20 years of jail time and fines up to $5 million. (Loeb 2005) In 2003 the ASX’s Corporate Governance Council introduced ten Principles of Good Corporate Governance which are non-compulsory. However, non-compliance should be justified which resembles the UK ‘comply or explain’ principle where non-compliance should be ‘explained.' The first ASX principle calls for ‘solid foundations for management and oversight’ while the second highlights the need to ‘structure the board to add value.’ Guidelines recommended to have a majority of independent directors in the board. Director independence is viewed as independence from management and ‘relationship that could materially interfere with … the exercise of their unfettered and independent judgement.’ (ASX, 2003) This principle is supported by the UK corporate governance guidelines as well. In the UK corporate governance based on a self-regulatory 'comply or explain' principle (Morrison, 2005), which is not legally binding, forming a soft law (Alexander, 2004, p.1005), where non-compliance results in de-listing of companies and their inability to enter London Stock Exchange, fraudulent corporate behavior was addressed in a number of recommendations - the Cadbury report of 1993 followed by the Greenbury, Hampel and Turnbull reports and Combined Code of 2003. Cadbury report recommends including at least three non-executive directors into the board structure, two of whom should be independent of the company, its management and “free from any business or other relationship which could materially interfere with the exercise of their independent judgement.” Non-executives are not allowed to participate in share option schemes and are not pensionable by the company. (Cadbury Report 1992) The ASX recommendations concerning the choice of a non-executive director include the following: one is not a company shareholder, has not been performing executive function or material professional advising for the company for the last three years, has no material contractual relationship with the company. (ASX, 2003)  Guidelines of both countries highlight the importance of non-executive directors independence. Director independence means unbiased control over the company management. Thus more reliable control mechanism is introduced. Separation of chairperson and chief executive officer positions The ASX’s Principles of Good Corporate Governance also recommend separating the roles of chairperson and chief executive officer. The chairperson should be an independent director and nomination committee, consisting of at least two independent directors, should appraise board’s performance. UK policy maker Higgs, reviewing the effectiveness of non-executive directors, also suggests to divide responsibilities of the chairman and chief executive. When such division in responsibilities is not possible, the role of non-executive directors and independent directors in supervision of executives increases. The Cadbury report outlined the importance of non-executive director for the effectiveness of the board especially when the chairman is also the chief executive. As numerous researches suggest the efficiency of the board of directors as a monitoring organ with a chief executive officer being a chair of the board of directors is compromised. Agency theory predicts that if the chairperson of the board is not independent of executive management, then the interests of the owners are subordinated to some extent to the management interests. (Donaldson & Davis, 1991 p.50) The chairman plays a significant role for non-executives’ work efficiency. As in the case of HIH, where the chief executive Ray Williams appointed friends and associates to the board, resulting in non assessment of the management performance. The information was controlled by management, and non-executive directors had no power to influence any process inside the company. The board was dependent on the senior management failing to participate in any decision-making process. (Siladi, 2006 ) The information quality for better corporate governance in regulations Upgraded corporate governance regulations of Australia and the UK mention the quality of the information to be used by non-executive directors as an important factor for good corporate governance and independence of non-executives from company insiders. US Sarbanes-Oxley particularly focuses on the importance of information and supposes criminal penalties for the information destruction, altering or mutilation. Thus Sarbanes-Oxley highlights the importance of information and records management practices for the the trustworthiness and accuracy of business records. (Records Management, 2005) As non-executive directors have the equal access to the inside knowledge of the company, they perform not only control function but also participate in decision making process: “bring an independent judgement to bear on issues of strategy, performance, resources, including key appointments and standards of conduct.” (Cadbury Report 1992) Thus the board from its traditional function of appointing (dismissing) CEO and protecting shareholders’ interest shifts towards more complex functions – strategy formation, advice role, monitoring, risk management. Non-executive directors can bring various experiences and fresh look on the situation inside the company, being able to review strategies in more impassionate way. (Kiel &Nicholson, 2003) Thus non-executives add value by bringing an independent perspective to decision-making, exhibiting relevant experience and competency and at the same time monitoring the CEO and senior management. This new view on the role of non-executives is in contrast to an old view of the board sole responsibility being maximization of shareholders’ profits. Nomination, Remuneration and Auditing Committees Changes The efficiency of board and directors’ performance is related to the remuneration issue. The Corporations Act requires that directors’ remuneration must be approved by shareholders and disclosed in the financial statements. According to Principle 9 of the ASX guidelines remuneration committee being in charge of executive remuneration packages and incentive schemes for directors, should be composed of a majority of independent directors. The same practice was adopted in the UK. Australian Principles recommend setting audit committees composed of non-executive managers. US Sarbanes-Oxley requires independence of auditors who are to audit management’s statements about internal controls and to separately report their conclusions. (Kroeger 2003) Internal auditors are to ensure the highest standards of internal controls of the company by assessing controls and policies of the company and reporting directly to the audit committee of the organization, consisting mostly of independent members, one of whom is a financial expert. (Heinz, 2003) In the study of Evans and Evans (2002) it is indicated that the voluntary establishment of nomination committee by the Board of Directors suggests of the owner’s desire for a more independent board. This suggestion is in alignment with other researches (Shivdasani and Yermack, 1999) which connect the existence of a nomination committee with a more independent board. CONCLUSION. FUTURE DEVELOPMENTS IN CORPORATE GOVERNANCE: BOARD STRUCTURE FOCUS. All corporate governance systems throughout the world are grounded on the legal, regulatory and best practice elements. (Morrison, 2005) In the recent two decades corporate governance in respect to director duties has changed due to inadequacy of the current system. Corporate scandals all over the world were speaking evidence to this. Many countries reviewed their regulations, particularly what concerns the work of the directors. Australia and the UK stressed on the importance on non-executive directors in the board composition in their regulations. Recommendations or regulations issued in each country converge in several issues concerning directors: the presence of independent non-executive directors in the board, participation of non-executives in nomination and remuneration committees, control and decision-making function of the executives, their fair remuneration. The trend of including more non-executive directors in the board structure is growing. After the adoption of ASX’s Corporate Governance Principles, the number of non-executive directors in the board composition markedly increased. Including non-executive directors into the board structure reduces the apparent conflict between management and shareholders. Non-executive functioning within the company seems to be the current response to corporate governance problems all over the world. Corporate scandals showed the gaps in the corporate governance mechanism, which was addressed by legislators in different countries. While Australia and the UK issues recommendations based on ‘comply and explain’ principle, the USA introduced more severe measures where non-compliance results in criminal punishment. Recent reforms in Australia, the USA and the UK had all concentrated on the issues of board independence, independence of remuneration and audit committees, highlighted the need of separating CEO and chairman positions. The independent structures within the company ensure reliable control over the management of the company and shift the responsibility for the company effective work and high performance on directors. Thus the reforms provide adequate mechanisms for the directors to audit management’s performance and carry responsibility for their actions. The reforms mentioned in the paper have important implications for shaping the best corporate governance mechanism. Regulations of Australia, the UK and the USA with their focus on independence of within company structures suggest of further convergence towards the best corporate governance system though it is still unclear if it will be based on Anglo-American pattern or it will be a hybrid model. The important corporate governance mechanism highlighted by recent regulations is independence of certain structures within the company. This approach assures safety mechanism, which balances the interests of different stakeholders. With the need to align the interests of shareholders and management, regulations introduce an independent party – non-executive directors, who make up auditing and remuneration committees, and who also perform decision-making functions. However, we suppose that the independence of non-executives may be compromised. Besides, they are people with impassionate view towards the matters of the company. Some theorists introduced the concept of ‘stakeholder inclusiveness’ which contributes greatly to adhering to the principles of corporate social responsibilities by the companies. (Berghe, 2002) This makes us assume that future developments will focus on safety mechanisms, which involve ‘network boards’ composed of stakeholders. These boards will provide information to non-executive directors to ensure their complete independence from management. They will also take over the role of nominating and remunerating committees. Thus we assume that corporate governance of the future is likely to rest on the network of boards and advisory stakeholder councils. Bibliography Alexander K., 2004. UK Corporate Governance and Banking Regulation. The Stetson Law Review, 33(2), pp. 991-1035. ASX Corporate Governance Council. Principles of Good Corporate Governance and Best Practice Recommendations. March 2003. Available at: http://www.ecgi.org/codes/all_codes.php [accessed 28 Jan 2008]. Berghe, L., 2002. Corporate Governance in a Globalising World: Convergence or Divergence? A European Perspective. Boston : Kluwer Academic Publishers. Cadbury Report (The Financial Aspects of Corporate Governance). 1992. The Committee on the Financial Aspects of Corporate Governance and Gee and Co. Ltd. 1 December Available at: http://www.ecgi.org/codes/code.php?code_id=132 [accessed 24 Jan 2008]. Coffee J. C Jr., 1999. The Future as History: The Prospects for Global Convergence in Corporate Governance and Its Implications. [Online] Columbia Law School Center for Law and Economic Studies. Working Paper No. 144. http://ssrn.com/abstract=142833 [accessed 24 Jan 2008]. Coffee J. C. Jr., 2005. A Theory of Corporate Scandals: Why the U.S. and Europe Differ. [Online] Columbia Law and Economics Working Paper No. 274. Available at http://ssrn.com/abstract=694581 [accessed 24 Jan 2008]. Corporate governance principles and recommendations. 2ne ed., Sydney: ASX Corporate Governance Council, 2007 Donaldson, L. & Davis J. H., 1991. Stewardship Theory or Agency Theory: CEO Governance and Shareholder Returns. Australian Journal of Management, 16 (1), pp.49-64 Evaluating board performance: a guide for company directors, Sydney: Australian Institute of Company Directors, 2007 Evans, Robert T. and Evans, John P., "The Influence of Non-Executive Director Control and Rewards on CEO Remuneration: Australian Evidence" . EFMA 2002 London Meetings. Available at SSRN: http://ssrn.com/abstract=263050 [accessed 24 Jan 2008]. Heinz P. A., 2003. Responding to The Sarbanes-Oxley Act Of 2002. The Financial Reporting Practices of Nonprofits. Available at The Alliance for Children And Families: www.alliance1.org/Home/SOX_final_8-03.pdf [accessed 11 Feb. 2008]. Ho, S. S.M., 2005. Corporate Governance in China: Key Problems and Prospects, Research on Applied Ethics. National Central University, Taiwan, 33, pp. 62-66 Jensen, M.C. & Meckling, W.H., 1976. Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3, pp.305–360 Kiel, G. C. & Nicholson, G. J., 2003. Boards that work: A new guide for directors, 1st Edition edn, McGraw-Hill, New South Wales, Australia. Kroeger, B., 2003. Reporting on Internal Controls: Lessons from the Banking Industry. Available at CrossCurrents www.atypon-link.com/AAA/doi/pdf/10.2308/acch.2005.19.3.137 [accessed 11 Feb. 2008]. Loeb, L., 2005. Executive Summary: Sarbanes-Oxley: Worse than No Solution at All? Available at Ziff Davis CIO Insight. http://www.cioinsight.com/c/a/Past-News/Executive-Summary-SarbanesOxley-Worse-than-No-Solution-at-All/ [accessed 11 Feb. 2008]. Moldoveanu M. & Martin R., 2001. Agency theory and design of efficient governance mechanism. University of Toronto. Morrison, J. E., 2005. Directors' duties and corporate governance. Avialable at: http://www.jamaica-gleaner.com/gleaner/efg/17-Feb-06/Commentary/comm3.htm [accessed 24 Jan 2008]. Records Management and the Sarbanes-Oxley Act. 2005. Available at www.omnirim.com [accessed 11 Feb. 2008]. Siladi B., 2006. The role of non-executive directors in corporate governance: An evaluation. Swinburne University of Technology. Yermack, D., 1996. Higher Valuation of Companies with a Small Board of Directors. Journal of Financial Economics, 40, pp. 185-212. Read More