The Role of Corporate Governance Mechanism of Independent Directors - Essay Example

?The Role of Corporate Governance Mechanism of Independent Directors In this paper the mechanism of independent directors under the guidelines of Corporate Governance will be analyzed to see how effectively it was designed and how well it has been implemented in the real life. The mechanism suggests that the Board of Directors should comprise of an equal numbers of executive and non-executive (independent) directors. Executive directors are responsible for the management of the company’s operations whereas the non-executive directors, which are appointed by the shareholders, are responsible for the supervision of the executive directors’ performance as a whole. Under the framework, the independent directors are responsible for setting up board committees, which govern the performance of the board. These committees include audit committee, remuneration committee and nomination committee. The audit committee supervises the reporting of the financial statements between the management and the shareholders of the company, remuneration committee is responsible for devising remuneration packages for the executive directors of the board after considering their performance and the nomination committee is responsible for nominating directors that can become the part of the board after elected by the board of directors. This whole framework is then observed in the real life examples of various organizations in UK, so as to see how effectively the mechanism has been applied and how well it is performing in achieving the main purpose of the framework. The Role of Corporate Governance Mechanism of Independent Directors According to the Cadbury report (1992), Corporate Governance has been defined as ‘the system by which companies are directed and controlled (P 15, paragraph 2.5).’ The system states that the board of directors is assigned the responsibility of governing the companies on the behalf of the shareholders, whereas the shareholders are in charge of appointing a board of directors along with auditors, so that they can be satisfied that a suitable system of governance is in place. In this paper the mechanism of independent directors, defined by the Corporate Governance, will be discussed to see how this mechanism works for the effective execution of governance. The concept of independent directors was originally acquired from the Anglo-American model of Corporate Governance, where there was a unified structure of board of directors. The main reason behind the concept was to apply checks and controls where there was a separation between ownership and control of the organization (Ali and Gregoriou, 2006). Recent progress in economic theory suggests that the appointed board of directors play a vital part in the effective governance of a corporation. With the authority to hire, fire and compensate the senior management of the company, the board of directors ensures that the problems relating to the conflicts of interest among the shareholders and the management are resolved and controlled. This contributes to economizing the transaction costs (also called the agency costs) that arises as a result of the separation of ownership and control, thus facilitating the existence of an organization as an open corporation (Baysinger and Butler, 1985). The basic agency problems that arise as a consequence of the separation of control and ownership include; managers acting in order to serve their personal interests, non-transparency of financial performance between the managers and the shareholders in order to portray a better picture of the company’s performance by keeping the shareholders in the dark and the management’s motivation to focus on short term performance and manipulation of the financial performance in order to secure incentives (Rezaee, 2007). In order to overcome these issues corporate governance defined a framework of board of directors to introduce independent directors into the structure. The directors managing the operations of the company were defined as the executive directors where as the independent directors, who play no part in the management of the operations are called the non-executive directors. The non-executive directors are hired by the shareholders of the company. According to the framework, at least half of the board should comprise of independent non-executive directors where chairman and the chief executive officer of the company cannot be the same person and the board’s chairman is independent of the operations of the company. Also it requires the board to evaluate its performance rigorously especially that of its committees and individual directors and the executive as well as non-executive directors should be re-appointed only after a rigorous review of their performance and after a specified duration of time (Solomon, 2008). The main purpose of such board structure was that while the executive directors manage the operations of the company, the non-executive directors should act independently, of the operations of the company, to make sure that the best interests of the shareholders are kept in mind while decision making processes. It was their role to set up committees for the proper execution of the responsibilities and to carry out annual evaluation of all the directors of the company including the chairman, so that the corresponding disclosures in the annual reports could be made to the shareholders. The framework devised a set of board committees that should be established to manage main responsibilities like audit of the financial statements, remuneration, and nomination of the perspective directors of the board. Audit committee acts as a liaison between the independent external auditors and the management of the corporation. It is the responsibility of the audit committee to appoint the external auditors, who eventually report to them regarding the financial performance of the company so that a transparent full disclosure can be ensured among the company and its stakeholders. Under the framework the audit committee should only comprise of independent directors (Dravis, 2007). A remuneration committee is responsible for determining the remuneration packages for the executive directors of the company and under the framework it should only comprise of non-executive directors, so that no conflict of self interests arise. It is the responsibility of the remuneration committee to devise a remuneration plan that reflects the performance of the executive directors and is compatible with the remuneration packages that are offered by other companies in the market so that the interests of the employees are also kept in mind. The nomination committee is responsible for the management of processes that are associated with the appointment of new directors. It is its responsibility to identify new directors that can become the part of the board and then to conduct elections so that the whole board participates in the election of a board member. The nomination committee should also be comprised of only the non-executive directors according to the framework (Institute of Directors, 2004). All of these committees’ structures and policies should be supported by separate documents narrating the terms of references and the composition should be fairly disclosed. The terms of references should include all matters indicated by the Combined Code. All these elements of the mechanism of independent directors are to ensure that a supervisory role is established over the managerial board of a corporation so that the shareholders’ interests are not compromised. Now it shall be observed that how the mechanism of independent directors is implemented in the real life and how effective it really is. In UK, to be listed on London stock exchange market it is mandatory to follow corporate governance and if a company has not yet established proper measures regarding the implementation of corporate governance then it cannot be registered on the market. For the purpose of this paper, UK’s construction companies are being focused on. The companies under consideration here are Belfour Beatty and Interserve. We will analyze how all of these companies have incorporated corporate governance into their organizations and it will be observed that how effectively they are into place. First of all, according to the framework the board structure should comprise on equal numbers of executive and non-executive directors. In Belfour Beatty the board of directors comprises of twelve directors in total out of whom, seven including the chairman are non-executive directors that mean that in the total composition of the board seven are non-executive directors whereas five are executive directors. In Interserve the Board of Directors comprise of five non-executive directors including the chairman and six executive directors. Thus it is clear that so far all of these companies have followed the requirement of composition of the board of directors. It’s the Board’s responsibility in all these organizations to make strategic decisions, approve and release the financial performance of the companies on quarterly and yearly basis and approve dividends for the shareholders in the light of the companies’ financial performance. Thus all these non-executive directors have the responsibility to govern the performance of the company and the executive directors so that the above mentioned responsibilities are carried out fairly without creating any conflicts of interests among the management board. The mechanism suggests that the board of directors should establish a set of committees to manage the key areas of governance. All of these committees will be observed individually in these companies. All the committees of Balfour Beatty are supported by the company Secretary or nominee. The company has a well established audit committee, whose main responsibilities are to govern the reporting of the financial statements, financial controls, manage the external as well as internal audit, and managing risk assurance and management. The committee conducted meetings four times in the year of 2010. The remuneration committee is comprised of five non-executive directors, whose main responsibilities are to design remuneration strategy and policies as well as remuneration packages for the directors. They also have conducted four meetings in the year 2010, where the CEO was invited to participate whenever appropriate. The nomination committee comprises of eight directors which are a combination of non-executive and executive directors. Their main responsibilities are to manage the structure and the composition of the board, appointment of non-executive directors and succession planning and talent management. The nomination committee has conducted meetings only once in the year 2010. Along with these main committees the company also has the committees for business practices, group tender and investment and finance and general purposes. All the directors of the company have interests in the shareholdings of the company and its subsidiaries. The audit committee in Interserve comprises entirely of non-executive directors, whose main responsibilities are to coordinate with the company’s chief finance officer as well as the external auditors. It advises the company on the interim and final management of financial statements and provides an independent overview on the company’s internal controls and risk management. It is the committee’s responsibility to manage the internal and external auditors. The nomination committee of the company comprises of the Chief Executive officer, the Chairman of the company, one Senior Independent Director along with at least two other members whose status as executive or non-executive has not been specified. The responsibilities of the committee include the managing of the board’s structure and skill set. The committee also recommends the potential successors to both the executive and non-executive directors. It also makes recommendations to the board regarding the membership and chairmanship of board committees. The nomination committee conducts a meeting every year. The remuneration committee consists entirely of non-executive directors, and conducts a meeting at least once every year. The committee consults with the chairman or the chief executive officer. The chief executive officer has the right to address any meeting of the committee unless there is a conflict of interest. The responsibilities of the remuneration committee constitute the determination of remuneration for the executive directors, the company secretary and the chairman as well. It also determines their service agreements with the company. It also sets the performance targets for the company directors and administers any rewards associated with the achievement of the targets. It reports its work to the board as a whole. The discrepancies in the company’s frameworks can be easily observed now. As far as Balfour Beatty is concerned it should not consult the chief executive officer during the meetings of the remuneration committee. The Combined Code states that the remuneration committee should comprise of non-executive directors only so that the conflicts in interests can be avoided between the management board and the shareholders of the company. Consulting the chief executive officer can jeopardize that. The nomination committee should also be comprised of non-executive directors only which is not the case with Balfour Beatty. Having executive directors on the nomination committee can lead to a biased selection of prospective members of the board of directors, which might jeopardize the integrity of the strategic decision making process in the future. The situation in Interserve is also somewhat the same or may be a little adverse. The chief executive officer is a part of the nomination committee, along with two other directors whose status is not clear as to whether they are executive or non-executive directors. This can lead to same risks as mentioned in the case of Balfour Beatty. Furthermore, the committee suggests the successors to the executive as well as non-executive directors where as the Combined Code clearly states that the non-executive directors are appointed by the shareholders. The remuneration committee suggests the remuneration packages for both the executive and non-executive directors, care should be taken in this matter by Interserve so that the process of determining remuneration is not compromised as the chairman’s and chief executive’s remuneration is also carried out by the same committee so there is no one to govern the process. In a nut shell, the corporate governance compliance of Balfour Beatty seems way better than that of Interserve. Balfour’s committees conduct frequent meetings on a regular basis, where as Interserve’s committees conduct meetings only once a year. And the committees also seem to be closely associated with the executive board which is against the rules stated by the framework of corporate governance. To enhance the effectiveness of the mechanism, measures should be taken to overview the company’s efforts to comply with the framework of corporate governance on a regular basis. A committee should be set by the government to carry out these procedures. What ever steps the company takes regarding its compliance with the Combined Code; the company should transparently disclose it. As already the rule has been established by the UK stock exchange that any non-compliance with the Combined Code will result in the termination of company’s listings from the market, it should be ensured that the company submits regular reports as to represent its compliance with the framework of corporate governance. Bibliography COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE (LONDON, ENGLAND), & CADBURY, A. (1992). Report of the Committee on the Financial Aspects of Corporate Governance. London, Committee and Gee., Available at: [accessed at: 27-Jan-2012] ALI, P. A. U., & GREGORIOU, G. N. (2006). International corporate governance after Sarbanes-Oxley. Hoboken, N.J., John Wiley BAYSINGER B.D, & BUTLER, H.N, Corporate Governance and the Board of Directors: Performance Effects of Changes in Board Composition, Journal of Law, Economics, & Organization, Vol. 1, No. 1 (Spring, 1985), pp. 101-124, Oxford University Press, Stable URL: http://www.jstor.org/stable/764908 REZAEE, Z. (2007). Corporate governance post-Sarbanes-Oxley: regulations, requirements, and integrated processes. Hoboken, N.J., John Wiley & Sons. SOLOMON, J. (2008). Corporate governance and accountability. Chichester, Wiley. DRAVIS, B. F. (2007). The role of independent directors after Sarbanes-Oxley. Chicago, Ill, ABA Section of Business Law. INSTITUTE OF DIRECTORS. (2004). The handbook of international corporate governance: a definitive guide. London, IOD BALFOUR BEATTY, Composition of Board, Available at: < http://www.balfourbeatty.com/index.asp?pageid=175> [accessed at: 27-Jan-2012] BALFOUR BEATTY, Composition of Board Committees, Available at: < http://www.balfourbeatty.com/index.asp?pageid=176> [accessed at: 27-Jan-2012] INTERSERVE, Composition of Board and Board Committees, Available at: [accessed at: 27-Jan-2012] Read More