Role of Directors in Corporate Governance - Example

Non-Executive Directors Are a Waste of Time” Introduction It may be commonly perceived that non-executive directors are a waste of time. It may also be perceived that such directors often have little involvement with a company and are not aware of what is really going on and that the their role would rather be left with the executive directors. This may have been true in the past and with regard to private companies. For instance, the great majority of private limited companies in the United Kingdom have not in past selected non-executive directors to their boards (Ince & Company International Law Firm, 2008). It was generally considered that non-executive directors were appropriate only for publicly quoted companies and bigger private companies. Indeed, very few papers were written in support of small enterprises having non-executive directors (Berry & Perren, 2001). But the trend has changed in the recent years, as more and more medium size and bigger private companies have been appointing non-executive directors. There are many reasons for these appointments and as such, this paper takes a position against the notion that non-executive directors are a waste of time. As it will be shown in the paper, non-executive directors indeed have a great role to play in matters that pertain to the success of the company. The review is based on analysis of agency, stewardship, stakeholders, and resource dependence view of directors’ roles and responsibilities. Role of directors in corporate governance Governance of companies is viewed to be the responsibility of the board of directors who set the company’s strategy, monitor managers and report to shareholders on their stewardship. In fact, it is against a backdrop of the roles of the board of directors that the Committee on the Financial Aspects of Corporate Governance (1992) in the United Kingdom defined corporate governance as “…the system by which companies are directed and controlled” (Smith, 2007, p. 807). The fundamental legal duties of directors are to act in good faith with respect to the interests of the company and for an appropriate purpose. Company directors are also expected to exercise care and skill in the management of the affairs of the company. These functions are derived from common law and apply to all directors. There has been an argument that non-executive directors should face less onerous duties than their executive counterparts because they will inevitably be less informed about the company’s operations (The Committee on Corporate Governance, 1998). However, as it is discussed in the subsequent sections of this paper, non-executive directors have a crucial role to play to ensure the wellbeing of the any given company. In essence, successful corporate governance as noted by the Committee on the Financial Aspects of Corporate Governance requires a code of practice that includes the consideration of separate roles of the chairman and the chief executive, the balance between the executive and non-executive directors, and effective reporting on the company’s position as well as the effectiveness of its system of internal controls. It is noteworthy that the Committee on the Financial Aspects of Corporate Governance was formed after the collapse of companies such as BCCI and Maxwell as a result of major scandals (Smith, 2007). As Solomon (2010) points out, each firm should be headed by an efficient board, which is jointly accountable for the firm’s success. The role of the board is to offer entrepreneurial management of the firm within a framework of effective and prudent controls which facilitate assessment and control of risk (Solomon, 2010). The board should define the company’s strategic aims and make sure that the requisite human and financial resources are available for the company and review management performance. The company board is also required to set the company’s values and standards and ascertain that its obligations to its shareholders and other parties are understood and met. It is worthwhile that all directors must take decisions judiciously in the interest of the company. In sum, the synergy between executive and non-executive directors is expected to raise the level of accountability within the company, which is essential for averting scandals such as those involved in the collapse of Enron, WorldCom and the corporate collapses in the United Kingdom. This is discussed under the sections below. Board agency Going by the mechanisms by which board members are nominated and elected, it is evident that the board’s agency may be apparent in any action of a director that is aimed at being accountable to the shareholders. In practice, board structure intercedes through the development of modalities of legitimation, domination and signification that limit or organise the directors’ actions. Since members of the board have some bearing over the modalities that are initiated (such as the TSE Guidelines for Improved Corporate Governance in Canada), agency may influence the board structure (Lehman, 2005). The direct citation of essential guidelines in company annual reports can be considered as both an effort to gain authenticity for the board, and as a wider attempt to legitimise the guidelines to underpin or entrench them as modalities prior to imposing regulations on the board (Lehman, 2005). It cannot be gainsaid the modalities developed by a board will be more relevant and applicable if the board comprises both executive and non-executive directors. Agency theory Agency theory posits that professional managers, by virtue of their superior knowledge and expertise, gain advantage of the firm’s owners (Adams, 1994). Simply put, managers have a conflict of interest with the views of shareholders. They aspire to maximise their own personal gains rather than maximising shareholder value. As such, managers as agents are motivated by their own personal interests. To get rid of this, it is appropriate to reinforce the interests of the company by having people who have a wider and neutral view of the company – that is non-executive directors. One of the most significant roles of the corporate governance system is to ensure the quality of the financial reporting process. Board members act as agents of owners and are being increasingly held responsible for controlling the actions of management and for evaluating and implementing effective control systems. Recent legislation and the major stock exchanges now obligate boards to have a majority of external directors and audit committees to have three independent directors (Pergola & Joseph, 2011). Company stewardship According to Sadgrove (2005), an essential element of good corporate governance is the role of the non-executive director. Non-executive directors are expected to be responsible for monitoring executive behaviour but should also play a role in the development of company strategy. Hence, the recruitment of suitable non-executive directors can aid in lessening the likelihood of a wide variety of risks. Along this line, the Higgs report (2003) into the role of non-executive directors in the United Kingdom recommended that at least half of the company board should be independent, as should all members of the audit and remuneration committees, as well as a majority of the committee for nominating the board (Sadgrove, 2005). The Higgs report made a significant finding that non-executive directors play an essential role in corporate governance in companies in the United Kingdom. Hence, according to the report, from the perspective of the United Kingdom productivity and competitiveness, the progressive strengthening of the role of non-executive directors was strongly desirable (Higgs, 2002). Non-executive directors have a major role to play in constructively challenging and helping develop proposals on strategy. Non-executive directors should thus scrutinise the performance of management in achieving the agreed goals and objectives and supervise the reporting of performance. They should also satisfy themselves on the integrity of financial controls and financial information and systems of managing risk are robust and justifiable. Essentially, non-executive directors are responsible for determining the proper levels of compensation of executive directors and have a key role in selecting, and where required removing, executive directors as well as in succession planning (Solomon, 2010). As company finances are becoming more transparent and reporting more extensive, it is obvious that it will be more difficult to find experienced people willing to serve as non-executive directors. As opposed to an earlier standpoint that non-executive directors have a lesser role to play, their work is now more onerous and serious than it was, and these directors risk being sued if the company collapses (Solomon, 2010). In view of this, essentially the role of a non-executive director is to offer what can be termed a “creative contribution” to the board of directors by giving objective advice and criticism. It is for this reason that according to Ince & Company International Law Firm (2008), it is widely accepted today that non-executive directors have an important contribution to make to the effective management of companies. As there is no legal distinction between executive and non-executive directors, unitary board structures, such as that of the United Kingdom, non-executive directors essentially have the same role as their executive colleagues. Even though it is understood that non-executive directors cannot give the same continuous attention to the operations of the company, it is important that they show the same level of commitment to the company’s success as executive directors (Ince & Company International Law Firm, 2008). Pass (2004) and Barrow (2001) discuss a number of major reasons why companies need non-executive directors. First is that in legal and commercial terms, they are seen as an important guarantee of accountability and integrity of companies. It is believed that the interests of stakeholders in the company will be safeguarded by the presence of non-executive directors who can practice independent judgement. The second point is that non-executive directors can avail valuable external business knowledge to the affairs of the firm. It is inarguable that non-executive directors can always perceive risks and opportunities for the company, which might have been ignored by the company’s executive directors who are occupied with the day-to-day running of the company. Third, the function of the non-executive director can be especially significant when the chief executive or the executive chairperson of the organisation is overtly entrepreneurial or arrogant by moderating expenses. The non-executive directors who are well-connected can provide business opportunities that would otherwise be unavailable. Finally, the fifth point regards companies that require non-executive directors to see them though a period of corporate transition such as during change of ownership, repositioning of the company’s strategies and so forth (Pass, 2004). In such as cases, it can be noted that indeed it is not a waste of time for a company to have non-executive directors. It also important to mention that non-executive directors offer impartial advice to companies since a majority of them owe their loyalty to an outside external organisation. Additionally, non-executive directors have been shown to be very helpful in bringing a breadth of managerial experience early in a firm’s life (Barrow, 2001). In spite of the outstanding roles of non-executive directors as discussed above, it is also important to mention that there are potential limitations on their effectiveness. To begin with, non-executive directors are only appointed on a part-time basis and are therefore likely to be committed elsewhere. Consequently, they may not be in a position to devote sufficient time to the company to clearly understand the needs of the company or what is going on. It is for this reason that the National Association of Pension Funds imposed a limitation on the number of non-executive directorships an individual can hold at the same time to five. Second, there is no guarantee that non-executive directors have the expertise to understand all the highly technical and complex business issues. This is particularly worse in case they lack of information either because it is unavailable, or because it is withheld from them. This may imply that such directors may make only little useful contribution the company (Pass, 2004). Stewardship theory According to the stewardship theory, the behaviour of the stewards is collective as the steward strives to obtain the objectives of the company (that is sales increase or profitability). This behaviour will in turn benefit principals such as external owners through the implications of profits on share profits and dividends. As such, the manager believes that by working towards organisational goals, personal needs are also covered. These conflicting interests are cleared by the roles played by both executive and non-executive directors as discussed above (Siladi, 2006). Stakeholder Traditionally, the stakeholder was the main focus of directors’ roles (Siladi, 2006). This has however changed as companies now have to take into consideration the interests of diverse groups in social, ethical and environmental perspectives. Stakeholder theory The stakeholder theory is of the view that companies and societies are interdependent and thus the corporation serves a broader social purpose to fulfil the responsibilities it has towards shareholders. According to Hage (2007), for effective corporate governance, the stakeholder must ensure, at a certain distance, that the strategy and policy in a company is the non-executive board. Along the same line, the non-executive director has to operate in the best interest of the firm and not in the best interest of the shareholder. Boards members and particularly non-executive directors, have to contribute actively in the management of companies. Where directors only follow the directions of the management, the board is considered to be playing a passive role. Non-executive directors as it was discussed earlier, are expected to supervise managers. But where they fail they only come as a gratuitous cost to the company (Lazarides & Drimpetas, 2011). Protection of the interests of a company’s stakeholders requires multifaceted approaches. These include ensuring compliance with laws, regulations, as well as technical standards, by ensuring that there is equitable allocation of economic rents, by monitoring the decision-making processes of management to ensure that the decisions made will create long-term value for entity, and/or by ensuring that the information prepared and distributed by management is appropriate and of high quality (objective) (Pergola & Joseph, 2011). There is no doubt that these roles can be carried out effectively if there is a body that plays an oversight role within the company board. If well formulated, this body should be the non-executive directors. Company law in many countries recognises these roles; for instance China, the Netherlands and Germany have the board of management and a supervisory board. In Germany, the oversight board is by law made up of non-executive or independent directors and includes employee representatives 50 percent in firms that have over 2000 employees (Okpara, 2011). Resource dependence view of directors’ roles and responsibilities Boards must have directors who can proficiently express the interests of constituents both for economic and ethical reasons. Nevertheless, there is no clear peculiarity as to which between executive and non-executive directors can sufficiently meet these goals. Boards that are made up primarily of insiders (such as current or former managers/employees of the company) or dependent outside directors (those who have business associations with the firm) are regarded less effective in monitoring because of their dependence on the organization. On the other hand, independent boards – those that primarily consist of independent outside directors – are perceived to be the most effective at monitoring because their inputs are not compromised by dependence on the chief executive of the company (Ayuso & Aragandona, 2007). A different view however is that inside directors have more and better information about the company, which enables them to evaluate managers more effectively (Baysinger & Hoskisson, 1990). This perception fits with the resource dependence theory (Ayuso & Aragandona, 2007). Resource dependence theory Resource dependence theorists are of the view that a company is an open system, dependent on external organisations and environmental contingencies (Ayuso & Aragandona, 2007). The resource dependence theory focuses on the role of boards in attaining the required resources (such as skills, knowledge and capabilities) rather than using them (De Andre´s-Alonso, Azofra-Palenzuela & Romero-Merino, 2010). According to the theory, corporate boards are resource providers for the firm. Hence, directors may have the capacity to reduce environmental uncertainty by virtue of their network connections. Further, a firm that is able to reduce environmental uncertainty, particularly with reference to limited resources, is in a better position to attain its objectives. In relation to the theory it is the backgrounds and network ties of directors that affect their capacity to influence events in the firm’s favour and/or introduce additional expertise in the boardroom (Valenti, Luce & Mayfield, 2011). By linking the company with its external environment, resources help lower external dependency, reduce environmental uncertainty, and diminish transaction costs while improving the performance of the company. Both internal and external directors may contribute important linkages and resources to the board, but directors who have links with the current organisation will be more motivated to provide resources. But in spite of this assertion, a meta-analysis of fifty-four studies conducted in 1998 revealed no statistically significant relationship between board dependence and the firm’ financial performance (Ayuso & Aragandona, 2007). Thus to better understand the role of non-executive directors in companies, it is important to look beyond the resources that they bring to the company (which may be limited by the prevailing circumstances) and focus also on how actively the directors can use the available resources to chart a better path for the success of the company. As it was mentioned earlier, corporate governance concerns how firms are directed and controlled. The role of non-executive directors is therefore not only about bringing resources to the company (which is the focus of the resource dependence theory) but also formulating strategies to ensure that the resources are utilised in the best interest of the entire company. Conclusion This paper has taken a stance to oppose the notion that non-executive directors are a waste of time as they do not deeply understand the affairs of the company. As it has been discussed, corporate governance is increasingly embracing the role played by non-executive directors. This aspect has been analysed using the agency theory, the stewardship theory, the stakeholder theory and the resource dependence theory. Although it emerges that there are contradictory views on the role of executive and non-executive directors, it is evident that non-executive directors can bring new ideas into the company and may see risks that would otherwise not be perceived by executive directors. 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