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The Non-executive Directors and Corporate Governance

In 20th century 80years, in order to ensure fairness and transparency of board operations, rebuilding investor confidence. UK introduced the non-executive director system. The purpose of non-executive directors system is to reduce the agency costs, overcome the weakness of internal control, prevent the abuse of insider control rights. Also this system can protect the legitimate rights and interests of all shareholders, maintaining the company's interests and strengthening the supervision of the company's management. However, the outbreak of Enron, WorldCom and several big company's financial scandals shook the world’s finance and society. These scandals make people began to doubt the system of corporate governance, especially the efficacy of non-executive directors.

Based on such situation, this essay aims to through analysing several cases: Enron, WorldCom and The Equitable to investigate the strengths and weakness of perceived governance. Then it may illustrate what’s the role of non-executive in good corporate governance and give some suggestion.

Cases analysis

Enron

In December 2001, the largest U.S. energy trader, the market value up to 60 billion U.S. dollars-Enron went bankrupt. His dramatic bankruptcy exposed that the independent director system of Unite State is not perfect(Brickey,2003). As the most U.S. companies, Enron’s board was consisted of five sub-committees. On the surface, all of those committee operated very effectively and reasonably, the overall corporate governance structure seemed so “perfection”. However, the truth is the “independence” of directors was not as the Enron disclosed before. There was a number of independent directors had interest relationship with Enron, these delicate ties of cooperation impacted their position as an outside directors. For instance, the audit committee should assess and monitor the company’s internal controls, accounting independence and accounting standards. But when the Enron hired Arthur Andersen as external audit and consultant, they also created a series of partnerships with Andersen’s CFO and carried out a large number of complex transactions and manipulated earnings to cover up huge debts. This action apparently damage the company's internal control system. Incredibly, the audit committee has not questioned it, the laissez-faire attitude on the issue was so obvious(Palepu and Healy,2003). The other example is Enron's 17 board members, except the chairman and chief executive officer, the remaining 15 directors are all independent directors. But there were almost 10 people signed a consulting contract with the company and have a common link with charitable organizations. The board of Enron was clearly like a club which has strong internal links.

All these evidences indicate that the independent directors are not competent at work, they did not earnestly carry out the obligation on behalf of public shareholders and at a certain level acquiesced the fraud of Enron’s high-level executive. The independent directors have been seen as an important role who is standing at an objective and impartial position, protecting the interests of the company. It is widely expected that they can send a signal when the company has operation risk, also can apply warning to company's non-compliance and misconduct action. The bankruptcy of Enron exposed an important issue that the directors were lack of independence, the independent directors is not independent(Black et al,2003). And there exist the inadequacies and weakness of independent directors system, this system need to be reformed and improved. How to define the independence of non-executive and how to maintain such independence become a big problem.

WorldCom

If the Enron scandal is just the beginning, the WorldCom was no doubt the biggest financial scandals in the U.S history. In order to face the fierce competition in the telecommunications market, striving to grow capital strength to keep the technological promotion and implementing the outreach expansion strategy, the WorldCom adopted fraudulent accounting method to meet Wall Street earnings estimation(Sidak,2003). WorldCom’s board contained three specialized committee: audit committee, remuneration committee and nomination committee. However, the audit committee was basically only an empty title. There was none of the members had the specialized background of accounting and auditing, all of the members were formed by non-professionals persons. The monitoring effectiveness by such audit committee is can be imaged.

Moreover, the internal control also existed problem. The internal auditing does not directly response to audit committee, but directly accepted the CFO's leadership. Such behavior was lack of the minimum independence and increased the difficult of WorldCom Internal Audit Department to implement the accounting supervision, while deprived the power of the internal audit on the financial audit. The internal audit is mainly engaged in operating performance audit and audit of budget implementation, but the internal financial audit functions was outsourced to the Andersen. The financial accounting auditing and supervision has been weakened from double auditing and supervision to a single one. Because of the defect of WorldCom governance mechanisms, the fraud conspiracy was often succeed.

The Equitable

If the above cases were about the dereliction of duty of non-executive directors, then in 21st century, the most influential case in UK is the Equitable, this case indicates the more stringent obligation standards. In 2003, The Equitable life assurance society v. Roger Bowley and other 14 Directors was no doubt dropped a heavy bomb to the UK non-executive director who was facing the litigation. As the non-executive directors of insurance companies, they trust the company’s actuary was ruthlessly hit by the Court and presumed to be unreasonable. The Court judged the non-executive directors violated the duty of care. However, the non-executive directors believed that their approach is correct from start to finish and in such circumstances any of the rational non-executive directors would do the same thing as them. They argued that they are entitled to rely on the articles of incorporation and actuary, while the latter role to make recommendations on the issues about guarantees and dividend, also drawing them attention to the related problems. They debated that the actuaries dispel their concerns and assured them that if selected DTBP algorithm, there was no problems about the contract, and will not affect the expectations of insured. However, obviously the judge did not accept this explanation, he stated that the non-executive directors have obligation to conduct an independent judgement and monitor the management, they also should do more to ensure that the project is legitimate and will not cause the insured 's fear.

In this case the duty of non-executive director has been promoted to a very strict level, the non-executive directors can not simply rely on executive directors and senior officials to carry out their own duties. They must maintain their role as a monitor and exerting independent judgement on company's behavior. Apparently, this case seems a bit overkill, in this case if the non-executive directors trust actuary is not reasonable, then what the limit of reasonable reliance?

The non-executive directors

Based on above three cases, we will from three aspects to analyse how the non-executive directors play their role in “good” corporate governance.

The independence of non-executive directors

We can see that there exist a common point in above two cases, they all emphasize the essential of independence by non-executive directors. The independence means that the non-executive directors have to be independent with the company's management when they making decision and must consistent with the interest of firm’s shareholders. The independence of non-executive directors makes them plays an important role in corporate governance structure and play a special role in monitoring corporate management, controlling and balancing the right of shareholders and managers, also can protect the shareholder’s rights and interests(Enrione et al., 2006). Compared to the executive directors, the non-executive directors may stand more objective and fair position. For example, they can offer the added value proposals and suggestion by using their experience and knowledge when the company making strategy, also they will promote the company to comply the good corporate governance code.

However, in most cases, the non-executive directors can not achieve the real independence. Due to the interaction between non-executive directors and management, it may cause several issues for the operation of company(Daily et al., 2003). We can see this problem form Enron and WorldCom’s cases. The non-executive directors may be difficult to draw out of control by management, which makes them not only loss the regulatory functions, but also let the external investors reduce the necessary inspection of companies by trusting the non-executive directors’ reputation and experience. Finally, making the management fraud easily to succeed.

Therefore, the independence should mainly reflect in two aspects. First, the non-executive directors should be independent of major shareholders, namely, they should become the defender of the small shareholders. The second is they should be independent of operators, that is they should be the defender of the interests of all shareholders. To maintain the independence, they company should construct a reasonable voting rules, to ensure that the election of non-executive directors are truly not affected by major shareholders and actual controllers. But on the other hand, the "one hundred percent independent" also has shortcomings, the management should never be completely crowding outside the board, if the directors and the company can not connect in a appropriate level, the investors will also feel worry. So the most crucial point is to find a balance point between them.

The duty of care

Beside the independence, the duty of non-executive directors also become another debate point. When the non-executive directors enjoy the rights, at the same time they should also have a corresponding duty. Rights and duties are complementary symbion(Wade,2002). The duty of care is the basic factor for non-executive directors. There are two meanings for duty of care: First, as the non-executive directors of listed companies, their time and energy may be limited and may easy to neglect their duties, so they should be assigned to the duty of care which can promote them due diligence services for companies. Second, the duty of care also requires the non-executive directors must have the suitable ability and knowledge to provide protection for their role(Rousseau,2005). However, in fact, there exist a difficult and doubt on judgement of whether the duty of care is enough or not. For instance, in the Equitable case, the judge adopted the more strict standard on duty of care and this cause the controversy of imbalance between non-executive director’s reward and duty. By contrast, the too loose duty of care will also lead to the dereliction of duty, such as Enron and WorldCom cases.

The non-executive directors are not the company's decoration, but the substantive elements of corporate governance. A director who accepted the position whether the executive or non-executive directors have the responsibility to understand the character of their obligation(Atkins,2004). But it must be stressed that the extent of duty of care depends on the particular company's rules mode and scope of operations, as well as the skills and expertise of individual directors. In other word, a qualified non-executive directors should have professional qualification, experience and knowledge. And only at a non-executive director does his best efforts that can be considered to fulfill the duty of care.

4.Conclusion

The non-executive director is integral component of the board, the introduction of non-executive director system is hoping that it can reduce the faults through the company’s decision-making process and preventing the individual major shareholders encroach the community and small shareholders’ interests. The general condition of corporate governance in Europe, U.S. and other countries are rather good, we can not because some failure cases to negate the whole. Because the non-executive directors have the special function which can not be replaced by other monitoring mechanisms. But the system of non-executive need to reform, improve and strengthen. The non-executive director is not only an honor, more of a responsibility.

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