In
January 2003, the British government published the Derek Higgs’ Report1
on the role and effectiveness of non-executive directors on British corporate
boards. The UK government’ initial request for the report came in the wake of worldwide
corporate scandals at the beginning of the new millennium (BCCI Bank, Enron,
Worldcom, Marconi…). Its aim was to provide new tools to avoid the emergence of
any significant corporate governance problem within a British corporation by
strengthening the Combine Code of Corporate Governance (now, the UK Corporate
Governance Code2)
and, more specifically, by reviewing the selection and the duties of
non-executive directors, as they often appeared to play an important role in
these scandals. Like in many legal system, the Higgs as well as the 1992
Cadbury Reports3
perceive non-executive directors (NEDs) as a cornerstone for an efficient
corporate governance structure. One
may define corporate governance as “the system by which companies are directed
and controlled” (Cadbury, 1992). NEDs seem, therefore, to fit this definition
since their two main functions are to monitor executive activities and
contribute to the strategic development of the corporation. However, even if
this idea makes a relative consensus within the academic and professional
community, some authors still advocate that NEDs are pointless like “baubles on
a Christmas tree”4
regarding the monitoring function, or at least that they are unable to fulfil
their supervising duty because of several reasons. That said, instead of
debating the effectiveness of NEDs’ monitoring power, one may try to find a way
to improve it. Indeed, following the corporate scandals of the beginning of the
century, two different approaches were adopted on each side of the Atlantic to
promote independence of the board. While most of the European countries chose
self-regulation as a way to enhance supervision, the US Government took the
decision to codify binding legal rules so as to promote efficient supervisory behaviour
from the Board. While discussing the role of NEDs, one may try to consider the
debate about the need for regulatory reform regarding the function of NEDs for
an efficient corporate governance system. First one may focus on explaining the
significant role of the NEDs to an effective system of corporate governance.
Secondly, one may analyse whether it is appropriate to legally bind the NEDs in
their monitoring function. Finally, one may address the need, above all, to
solve intrinsic and fundamentals issues that prevent NEDs to fulfil their
function properly.

 

 

Corporate
failures and scandals of the last two decades have highlighted the need for
better control mechanisms to reduce abuse and self-interest within corporate
management. As a consequence, the role of NEDs has been emphasized and
attracted much of the attention of regulators. During the last two decades, corporate
governance reforms tried to increase the proportion of NEDs within the Board. Following
the recommendations of the Higgs Report, the UK Corporate Governance Code advocates
that “at least half the board (…) should comprise non-executive directors determined by the board to be
independent”5. Indeed,
according to the traditional view, NEDs are seen as responses to corporate
governance 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 various
committees such as the Remuneration Committee7
or the Audit Committee8.
As member of the Board of directors, NEDs are subject to director’s duties
codified 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”10
in a corporation; the first one is to supervise and monitor executive activity
so as to prevent any abuse or self-interest, the second is to contribute to the
strategy development of the corporation. Because NEDs have most of the time a
breadth of experience, some specialist knowledge and particular personal
qualities, the latter function is without a doubt easily achieved11.
Regarding the monitoring function, the importance of the NEDs come from their unique
position in the corporation because they serve on the board alongside the
executive directors which make them closely connected to the significant
information and to the decision making12.
Moreover, according to the agency theory, decision-making responsibility is
delegated by shareholders to executives which causes potential agency costs. But
because 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 of
integrity and accountability of corporations. It is, therefore, a significant
incentive for investors because they know that the interests of those who
invest in the corporation will be safeguarded by the presence of non-executives
who can exercise independent judgment15.
And like Jill Solomon wrote in his definition of corporate governance, “‘good’ corporate governance (…) is linked
significantly to good corporate financial performance”16.
Empirical evidence of the effectiveness of NEDs support some recognition of
their relevance to safeguard corporate accountability. Some studies advocated
the idea that NEDs (mostly independent and with financial expertise) are
valuable in monitoring a firm’s financial reporting practices17.
Other empirical studies were consistent with the idea that NEDs may protect
shareholders’ interest because of their core role in fundamental decisions
taking such as CEO substitution or the reaction to potential takeover18.
However, the 2008 financial crisis showed that NEDs were unable to provide an
effective and durable corporate governance system.

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To
render the NEDs’ function more efficient, some commentators suggested that clarifying
their role was the best answer. But two different approaches were adopted each
side of the Atlantic after 2002. Most of the European countries tried to better
define the duties and the ‘good practices’ that one may expect from NEDs through
a principle based system19.
It was the case for the Cadbury or the Higgs Reports and more generally the UK
Corporate Governance Code is supposed to help boards to discharge their duties
in the best interest of the corporation. In the USA, the role of NEDs is not
only better defined but it is also enforced. Indeed, the opponents of
self-regulation thought that codification of binding legal rules should be the
first choice to improve corporate governance. In their view, the efficiency of
the role of NEDs can only be achieved through specific regulation, when the law
can make it clear about how the board should be structured, what standard of
independence the directors should follow and what role they should play. Clarity
and 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 be
always subject to legal liability. Such measure should improve the skill and
the performance of NEDs when taking corporation’s decision20.
It would also encourage NEDs to reconsider their responsibilities, since a
law-making process is more likely to catch the eye of the public21
and makes the work of NEDs easier to control22.
It was the purpose of the 2002 Sarbanes-Oxley Act in the USA which was strongly
criticized within the academic and professional community. Indeed, according to
the opponents of such reform, “no law or regulation alone can be a substitute
for the voluntary adherence to these principles”23.
Enforcing the role of NEDs requires defining their role and responsibilities in
clear terms, as the current UK Company Act 2006 only builds a basic framework of
principles to clarify he nature of duties. But in doing so, there is a high
probability that the cost of inflexibility and the risk of a poorly structured
statute might limit the benefits of such a reform24.
Moreover, it may be counterproductive to impose things when their effectiveness
is not proved. For instance, empirical studies still have difficulty to show a
positive correlation between independent boards and a good corporate governance25.
That is why the “comply or explain” approach allows a particular company to
build a corporate governance system that would better fit its own circumstances
and at lower cost.

 

 

It
is, indeed, questionable whether a ‘one fits all’ approach through legislative
measures would be the most efficient action to improve corporate governance. It
would be more appropriate, first, to solve fundamental issues that prevent NEDs
to fulfil their functions properly. In relation with the last paragraph, the
first issue can be resumed as follow: “non-executive directors (is) a task for
which no one is qualified”26.
Indeed, the duties of NEDs are so large that it may be useful to reduce them
and to make sure that NEDs are aware of what one may expect from them. Given
the limited NEDs’ time commitment to their role27,
some commentators, therefore, try to set limits on their duties and advocate
that 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 and
certification courses in order to prepare them to the tasks and duties that one
may expect from them29.
More important, is the debate about the incentives of NEDs. Indeed, on the one
side, the traditional view sees legislation as a strong incentive and holds
that the “development of a legal framework of accountability” may enhance the
governance role of NEDs, for instance by introducing a “gatekeeper liability”30.
On the other side, other commentators believe that this is not enough and argue
that NEDs should hold a “significant amount of company stock” because financial
incentives may be the best solution to involve efficiently NEDs in corporate
governance31.
According to some studies in the USA, there is, indeed, a ‘small’ but positive
relationship between non-executive stock ownership and firm performance32.
This kind of incentives would also limit the fact that, according to Morck33
and 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 have
been averted if directors asked serious questions and demanded clear answer”35.
Last but not least, the information asymmetry between the executive and the
NEDs appears to be one of the most significant issue for an effective corporate
governance system. The most efficient answer to this issue would be to
encourage NEDs to collaborate and work together with the executives and not to
overemphasizing the monitoring role which
could create a gap and distrust between the executives and the NEDs36.

 

 

All
in all, one may say that NEDs play a key role in the corporate governance
system. First, their professional and personal qualities bring an adding value
to the supervision and management of the firm. And secondly, their unique
position in the corporation allows them to have a bird’s-eye view of the
functioning of the firm. But the financial scandals during the last two decades
and the involvement of NEDs proves that their role remains improvable. As one
explained above, clarifying the role of NEDs is of utmost importance but
codification of binding legal rules may not be the best solution since it
creates inflexibility. Plus, it may be economically damaging to impose things
when their effectiveness has not been proved. The answer would probably be a
hybrid model between self-regulation and public control37
where corporations have the flexibility to establish their own governance
system but are controlled by external forces. Moreover, public authorities have
the duty to encourage the usage of such directors with strong incentives to
follow basic principles used as guidelines rather than inflexible standards.
But, first, it may be desirable to solve some key issues such as creating
incentives to act in the best interest of the shareholders or deterring asymmetry
information between executives and NEDs.

Finally,
although one may not advocate regulation of NEDs role, it is not excluded that
better control and regulation should be implemented
in other areas such as anti-fraud controls or information disclosure38.

1 Higgs, D. (2003). « Review of
the Role and Effectiveness of Non-Executive Directors ». Department of
Trade and Industry/ HMSO, London, Online at:
http://www.ecgi.org/codes/documents/higgsreport.pdf

2 FRC,
« The UK Corporate Governance Code » (April 2016), Financial Reporting Council, Available
online at :
https://www.frc.org.uk/getattachment/ca7e94c4-b9a9-49e2-a824-ad76a322873c/UK-Corporate-Governance-Code-April-2016.pdf

 

3 Cadbury A. « Report of the
Committee on the Financial Aspects of Corporate Governance » (1992).
Available at :
http://www.uksa.org.uk/sites/default/files/press_releases/19920727_uksa_on_cadbury.pdf

4
Expression attributed to Tiny Rowland whilst a director of Lonrho, 1994. Cited
by 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 Ibid
note n°2. The UK Corporate Governance Code, B.1.2.

 

6 Gutierrez M., Saez M.
« Deconstructing Independent Directors » (2012), 13(1) The Journal of Corporate Law Studies 63

7 Ibid
note n°2. The UK Corporate Governance Code, D.2.1.

8 Ibid
note n°2. The UK Corporate Governance Code, C.3.1.

9 Company
Act 2006, Chapter Two Part 10.

10 Ezzamel
M., Watson R. « Wearing two hats : The conflicting control and
management roles of non-executive directors » (1997), Corporate Governance. Economic, Management, and Financial Issues.
Oxford University Press, 312 p.

11 Pfeffer
J. and Salancik G.R. « The External Control of Organisations : A
Resource Dependance Perspective » (1978) New York : Harper & Row.

12 Long
T., Dulewicz V. and Gay K. « The Role of the non-executive director :
finding of an empirical investigation into the differences between listed and
unlisted UK boards » (2005), Corporate
Governance : An International Review. Vol 13, N°5

13 Newcomb
R. “The limitation of directors’ liability: A proposal for legislative Reform”
(1987), 66 Texas Law Review, 426

14 Roberts
J., McNulty T. and Stiles P. « Beyond Agency Conceptions of the Work of
Non-executives Director : Creating Accountability in the Boardroom »
(2005), British Journal of Management,
Vol. 16, S5-S26

15 Pass
C.L. « Corporate Governance and the Role of Non-Executives Directors in
Large UK Companies : An Empirical Study » (June 2004), Corporate Governance : The
International Journal of Business Society, Vol. 4 N°2

16 Solomon
J. « Corporate Governance and Accountability » (2007) John Wiley & Sons Ltd, 2nd
Edition, p. 15

17 Agarwal A. and Chadha S. « Corporate Governance and Accounting
Scandals » (2005) Journal of Law and
Economics, 48, pp. 371-406

18
Hermalin B.E. and Weisbach M.S. “Boards of directors as an endogenously
determined institution: a survey of the economic literature” (2003), Economic Policy Review, 9, pp. 7-26

19 Lebègue D., Picard J.P. « La Révolution discrète des Conseil
d’Administration » (2006), Le
Journal de l’Ecole de Paris, n°61, pp. 8-15

20
Daoud O. F. « A Model for the Role and Effectiveness
of the Non-Ecxecutive Directors » (2013), University of Leicester Faculty of Law, Thesis submitted for the
degree of doctor of Philosophy in Law. pp. 180

21
Yuan Zhao, « Corporate Governance and Directors
Independance » (2011), Edition
Wolters Kluwer, Chapter 2 : ‘The regulation on independant
directors – Codification or self-regulation ?’ pp. 37-60

22
Sheikh S. and Rees W. “Corporate Governance and Corporate Control –
Self-regulation or Statutory Codification?” (1995), Corporate Governance and Corporate Control, Edited by Cavendish
Publishing Ltd. Chapter 18, pp. 361-389

23
The Business Roundtable, « Principles of Corporate
Governance » (May 2002), A white
paper from The Business Roundtable, p. 5. Available at : http://www.ecgi.org/codes/documents/brt_may2002.pdf

24
Yuan Zhao, « Corporate Governance and Directors
Independance » (2011), Edition
Wolters Kluwer, Chapter 2 : ‘The regulation on independant
directors – Codification or self-regulation ?’ pp. 37-60

25
Bhagat S. and Black B. « The Non-Correlation Between
Board Independance and Long-Term Firm Performance » (2001), 27 Journal of Corporation Law, 231-274,
Stanford Law School

26
Whitehead P. « Non-executive directors : a task
for which no one is qualified » (2013), Financial Times. Available at : https://www.ft.com/content/33ec6b3e-9099-11e2-a456-00144feabdc0

27 Between 15 and 30 days a year. Higgs Report 2003.

28 Nolan R.C. « The Legal Control of Director’s Conflict of Interest in
the United Kingdom : Non-Executive Directors Following the Higgs
Report » (2005), Theoretical
Inquiries in Law 6.2, Vol. 6 : 413

29 Lückerath-Rovers M., De Bos A. « Code of Conduct for Non-Executive and
Supervisory Directors » (2011), Journal
of Business Ethic, n°100 pp. 468

30 Kirkbride J., Letza S. « Can the Non-executive Director be an
Effective Gatekeeper ? The Possible Development of a Legal Framework of
Accountability » (2005), Corporate
Governance : An International Review, Vol. 13 N°4. Blackwell
Publishing Ltd

31 Shen W. « Improve Board Effectiveness : the Need for
Incentives » (2005), British Journal
of Management, Vol 16, S81-S89

32 Ibid. Shen W. Based on an analysis of 2003 (Dalton, Daily, Certo &
Roengpitya).

33 Morck
R. “Behavioral Finance in Corporate Governance – Independent Directors and
Non-Executive Chairs” (2004) Harvard
Institute of Economic Research Discussion Paper N° 2037, 26 Pages.

34 Milgram
S. “Obedience to Authority” (1974) Harper
and Row Publishers, New York, 219 pages.

35 Dedu V., Turcan R. « An introduction to behavioral corporate
finance » (2012), Annals of Faculty
of Economics, Vol. 1 N°2, p. 472.

36 Ibid.
Shen W. (2005)

37 Ibid
Note n° 21. Yuan Z. (2011) p. 53

38 Ibid Note n°21. Yuan Z. (2011) p. 60