InJanuary 2003, the British government published the Derek Higgs’ Report1on the role and effectiveness of non-executive directors on British corporateboards.
The UK government’ initial request for the report came in the wake of worldwidecorporate scandals at the beginning of the new millennium (BCCI Bank, Enron,Worldcom, Marconi…). Its aim was to provide new tools to avoid the emergence ofany significant corporate governance problem within a British corporation bystrengthening the Combine Code of Corporate Governance (now, the UK CorporateGovernance Code2)and, more specifically, by reviewing the selection and the duties ofnon-executive directors, as they often appeared to play an important role inthese scandals. Like in many legal system, the Higgs as well as the 1992Cadbury Reports3perceive non-executive directors (NEDs) as a cornerstone for an efficientcorporate governance structure. Onemay define corporate governance as “the system by which companies are directedand controlled” (Cadbury, 1992).
NEDs seem, therefore, to fit this definitionsince their two main functions are to monitor executive activities andcontribute to the strategic development of the corporation. However, even ifthis idea makes a relative consensus within the academic and professionalcommunity, some authors still advocate that NEDs are pointless like “baubles ona Christmas tree”4regarding the monitoring function, or at least that they are unable to fulfiltheir supervising duty because of several reasons. That said, instead ofdebating the effectiveness of NEDs’ monitoring power, one may try to find a wayto improve it. Indeed, following the corporate scandals of the beginning of thecentury, two different approaches were adopted on each side of the Atlantic topromote independence of the board. While most of the European countries choseself-regulation as a way to enhance supervision, the US Government took thedecision to codify binding legal rules so as to promote efficient supervisory behaviourfrom the Board. While discussing the role of NEDs, one may try to consider thedebate about the need for regulatory reform regarding the function of NEDs foran efficient corporate governance system. First one may focus on explaining thesignificant role of the NEDs to an effective system of corporate governance.Secondly, one may analyse whether it is appropriate to legally bind the NEDs intheir monitoring function.
Finally, one may address the need, above all, tosolve intrinsic and fundamentals issues that prevent NEDs to fulfil theirfunction properly. Corporatefailures and scandals of the last two decades have highlighted the need forbetter control mechanisms to reduce abuse and self-interest within corporatemanagement. As a consequence, the role of NEDs has been emphasized andattracted much of the attention of regulators. During the last two decades, corporategovernance reforms tried to increase the proportion of NEDs within the Board. Followingthe recommendations of the Higgs Report, the UK Corporate Governance Code advocatesthat “at least half the board (…) should comprise non-executive directors determined by the board to beindependent”5. Indeed,according to the traditional view, NEDs are seen as responses to corporategovernance failure6.NEDs are appointed on a part-time basis and perform various duties including(in some cases) acting as the company’s chairman and sitting on variouscommittees such as the Remuneration Committee7or the Audit Committee8.
As member of the Board of directors, NEDs are subject to director’s dutiescodified for the first time in the Company Act of 20069: promote the success of the company and the duty of skill, care and diligence.In practice, they are “wearing two hats”10in a corporation; the first one is to supervise and monitor executive activityso as to prevent any abuse or self-interest, the second is to contribute to thestrategy development of the corporation. Because NEDs have most of the time abreadth of experience, some specialist knowledge and particular personalqualities, the latter function is without a doubt easily achieved11.
Regarding the monitoring function, the importance of the NEDs come from their uniqueposition in the corporation because they serve on the board alongside theexecutive directors which make them closely connected to the significantinformation and to the decision making12.Moreover, according to the agency theory, decision-making responsibility isdelegated by shareholders to executives which causes potential agency costs. Butbecause NEDs have less conflict of interest compared to the executives13,agency costs are then reduced by boards exercising decision control14.Plus, legally and commercially NEDs are perceived as an important guarantee ofintegrity and accountability of corporations.
It is, therefore, a significantincentive for investors because they know that the interests of those whoinvest in the corporation will be safeguarded by the presence of non-executiveswho can exercise independent judgment15.And like Jill Solomon wrote in his definition of corporate governance, “‘good’ corporate governance (…) is linkedsignificantly to good corporate financial performance”16.Empirical evidence of the effectiveness of NEDs support some recognition oftheir relevance to safeguard corporate accountability. Some studies advocatedthe idea that NEDs (mostly independent and with financial expertise) arevaluable in monitoring a firm’s financial reporting practices17.Other empirical studies were consistent with the idea that NEDs may protectshareholders’ interest because of their core role in fundamental decisionstaking such as CEO substitution or the reaction to potential takeover18.However, the 2008 financial crisis showed that NEDs were unable to provide aneffective and durable corporate governance system.
Torender the NEDs’ function more efficient, some commentators suggested that clarifyingtheir role was the best answer. But two different approaches were adopted eachside of the Atlantic after 2002. Most of the European countries tried to betterdefine the duties and the ‘good practices’ that one may expect from NEDs througha principle based system19.It was the case for the Cadbury or the Higgs Reports and more generally the UKCorporate Governance Code is supposed to help boards to discharge their dutiesin the best interest of the corporation. In the USA, the role of NEDs is notonly better defined but it is also enforced. Indeed, the opponents ofself-regulation thought that codification of binding legal rules should be thefirst choice to improve corporate governance. In their view, the efficiency ofthe role of NEDs can only be achieved through specific regulation, when the lawcan make it clear about how the board should be structured, what standard ofindependence the directors should follow and what role they should play.
Clarityand accessibility are arguably the key benefits of such codification. Moreover,once the NEDs do participate in the decision-making or supervising processes,they always need to be aware that their misconduct or weak performance will bealways subject to legal liability. Such measure should improve the skill andthe performance of NEDs when taking corporation’s decision20.It would also encourage NEDs to reconsider their responsibilities, since alaw-making process is more likely to catch the eye of the public21and makes the work of NEDs easier to control22.It was the purpose of the 2002 Sarbanes-Oxley Act in the USA which was stronglycriticized within the academic and professional community. Indeed, according tothe opponents of such reform, “no law or regulation alone can be a substitutefor the voluntary adherence to these principles”23.Enforcing the role of NEDs requires defining their role and responsibilities inclear terms, as the current UK Company Act 2006 only builds a basic framework ofprinciples to clarify he nature of duties. But in doing so, there is a highprobability that the cost of inflexibility and the risk of a poorly structuredstatute might limit the benefits of such a reform24.
Moreover, it may be counterproductive to impose things when their effectivenessis not proved. For instance, empirical studies still have difficulty to show apositive correlation between independent boards and a good corporate governance25.That is why the “comply or explain” approach allows a particular company tobuild a corporate governance system that would better fit its own circumstancesand at lower cost. Itis, indeed, questionable whether a ‘one fits all’ approach through legislativemeasures would be the most efficient action to improve corporate governance. Itwould be more appropriate, first, to solve fundamental issues that prevent NEDsto fulfil their functions properly. In relation with the last paragraph, thefirst issue can be resumed as follow: “non-executive directors (is) a task forwhich no one is qualified”26.
Indeed, the duties of NEDs are so large that it may be useful to reduce themand to make sure that NEDs are aware of what one may expect from them. Giventhe limited NEDs’ time commitment to their role27,some commentators, therefore, try to set limits on their duties and advocatethat the dual role should be abandoned in favour of the monitoring function28.Moreover, more recently, some commentators advocated the need for”professionalization” of the NEDs’ function through education, training andcertification courses in order to prepare them to the tasks and duties that onemay expect from them29.More important, is the debate about the incentives of NEDs. Indeed, on the oneside, the traditional view sees legislation as a strong incentive and holdsthat the “development of a legal framework of accountability” may enhance thegovernance role of NEDs, for instance by introducing a “gatekeeper liability”30.On the other side, other commentators believe that this is not enough and arguethat NEDs should hold a “significant amount of company stock” because financialincentives may be the best solution to involve efficiently NEDs in corporategovernance31.According to some studies in the USA, there is, indeed, a ‘small’ but positiverelationship between non-executive stock ownership and firm performance32.This kind of incentives would also limit the fact that, according to Morck33and based on Milgram’s thesis34,directors are more loyal to their direct boss (CEO) than to their shareholders.
According to the same author, “many corporate governance failures could havebeen averted if directors asked serious questions and demanded clear answer”35.Last but not least, the information asymmetry between the executive and theNEDs appears to be one of the most significant issue for an effective corporategovernance system. The most efficient answer to this issue would be toencourage NEDs to collaborate and work together with the executives and not tooveremphasizing the monitoring role whichcould create a gap and distrust between the executives and the NEDs36. Allin all, one may say that NEDs play a key role in the corporate governancesystem. First, their professional and personal qualities bring an adding valueto the supervision and management of the firm. And secondly, their uniqueposition in the corporation allows them to have a bird’s-eye view of thefunctioning of the firm. But the financial scandals during the last two decadesand the involvement of NEDs proves that their role remains improvable. As oneexplained above, clarifying the role of NEDs is of utmost importance butcodification of binding legal rules may not be the best solution since itcreates inflexibility.
Plus, it may be economically damaging to impose thingswhen their effectiveness has not been proved. The answer would probably be ahybrid model between self-regulation and public control37where corporations have the flexibility to establish their own governancesystem but are controlled by external forces. Moreover, public authorities havethe duty to encourage the usage of such directors with strong incentives tofollow basic principles used as guidelines rather than inflexible standards.But, first, it may be desirable to solve some key issues such as creatingincentives to act in the best interest of the shareholders or deterring asymmetryinformation between executives and NEDs. Finally,although one may not advocate regulation of NEDs role, it is not excluded thatbetter control and regulation should be implementedin other areas such as anti-fraud controls or information disclosure38.
1 Higgs, D. (2003). « Review ofthe Role and Effectiveness of Non-Executive Directors ». Department ofTrade and Industry/ HMSO, London, Online at:http://www.ecgi.
org/codes/documents/higgsreport.pdf2 FRC,« The UK Corporate Governance Code » (April 2016), Financial Reporting Council, Availableonline at :https://www.frc.org.uk/getattachment/ca7e94c4-b9a9-49e2-a824-ad76a322873c/UK-Corporate-Governance-Code-April-2016.pdf 3 Cadbury A. « Report of theCommittee on the Financial Aspects of Corporate Governance » (1992).
Available at :http://www.uksa.org.uk/sites/default/files/press_releases/19920727_uksa_on_cadbury.pdf4Expression attributed to Tiny Rowland whilst a director of Lonrho, 1994. Citedby R. J. Boxer in « Differing perceptions of non-executive directors’roles in privately owned UK small and medium-sized enterprises » (2010),PHD, University of Brighton.
Available at :http://eprints.brighton.ac.uk/12254/1/R%20J%20Boxer%20PHD%20Thesis%202010_Redacted.pdf 5 Ibidnote n°2. The UK Corporate Governance Code, B.1.
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