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Role Of Non Executive Directors In Uk Accounting Essay

This paper focuses on the penumbra of the role of non-executive directors in UK listed companies and tries to present both the bright as well as dark side of outside directors.

Introduction:

The birth of a corporation in early times was for the purpose of earning profit for the sole trader but it was not as complex an entity as it is today. Early form of corporations and business structures were very simple with the pivot of the family running and managing the business. The initial corporations were not having a separate legal identity and the control of the business as well as the assets was in the hands of the owner without the concept of shares and shareholders.

The idea of separation of ownership from control was for the first time propounded in 1932 by Berle and Means as an impact of which the actual owners were no more controlling the business. This task of managing the business was now assigned to professionals and highly experienced pupil, called the executives .This had some advantages as well as some drawbacks as it gave rise to a web of complex situations where the owners of the wealth were sitting back, not really participating in the day to day running of the business and the executives like directors and managers being entrusted with the fiduciary duty to carry out the business in the best interest of the actual owners as well as the society. The owners, who contributed in raising the capital for business in return of a share in the profit, were now being called as shareholders and the executives acted in the best interest of the shareholders as their agents creating an agency set-up. As it is human behavior to act in self-interest being in a highly powerful position, even when one is under a duty not to do so, the agents also acted in the same human behavior, serving themselves instead of serving the owners. This is what we called the agency problem, whereby the agents manipulate the profits, breach their fiduciary duty, act in their own best interest and the shareholders suffer and instead of getting an appropriate chunk of the profit they get the residual of the profit. The cost which the shareholders bear by this separation of ownership and control is called the agency costs.

Our economies have suffered huge losses and fallouts every now and then like the Enron, Paramalt, Barring Banks, Lehman Brothers etc due to this agency problem. From past couple of decades, the sole agenda of researchers, market experts and legislators has been to reduce these fall-outs and establish a fair and transparent market where the investors like shareholders have complete and accurate information about the companies. As the executives like the managers and the board of directors are at the core of this market, our aim of a perfect market can only be achieved by regulating, monitoring and controlling these executives so that they do not misuse their powers. A part of this process is the alignment of interest of shareholders with that of the management and board and reduction of agency costs. [1] Here the corporate governance comes into picture. All the economies of the world are trying to achieve a fool-proof corporate governance framework whereby we can have more transparent and sound markets, complete shareholder protection and less company failures. This cannot be regarded as the sole aim of corporate governance but this is the point where the theories of corporate governance like agency theory, stakeholder theory meet the practicalities of corporate world. The scope of this field is too broad. From protection of rights of a shareholder as an individual to welfare of all the stakeholders in the society, it encompasses and protects everything. Corporate governance is like the guide that shows the right direction to the ship instead of mechanically altering the engine of the ship so that it reaches the desired destination. [2] In order to achieve the perfect framework, it is essential to first monitor the core of the market, by controlling the powers of executive. For this purpose, after years of research, the legislators and advocates of good practices in the market came up with the institution of non-executive directors to supervise and control the highly powerful executives. Let’s see what does this term means.

Non-executive Directors:

Cadbury report very clearly addressed NEDs by saying that there are two kinds of directors on the board: [3] 

Board of Directors

Full-Time

They are appointed on full-time basis, that means they participate in the day-to-day running of the business.

They are mainly insiders,i.e they are already a part of the company and hence called insiders or executive directors.

Part-Time

They are sought on part-time basis, for a specific term, mainly due to their expertise in a specific area like banking, finance. etc.

They are always independent, which means they are not in any such relationship with the company, e.g. shareholding or previous employee; which can mentally affect their ability to give an independent judgment.

They bring an outsider’s perspective in the board room and hence are called outside directors or non-executive directors.

Fig. 1: Basics of executive and non-executive directors [4] 

This is not a very recent institution but what makes it interesting is its challenging role which is also the subject of this paper. A non-executive director, also referred to as an outside director is the person who is serving on the board of director but not related to the company in any other way. This means that he should not be a previous employee, shareholder or even stakeholder of the company. He should not have any exogenous or endogenous relations with the company in any way which would put him under any conflict of interest while serving his duty. The purpose of this strict condition is to keep him independent so that he can fulfill his role most effectively and efficiently. If a NED is not independent then it defeats the very purpose of having a NED on board as his appointment promises an independent and impartial voice in the boardroom. The independence of NED is not discussed in detail here but this paper does not doubt the importance of independence of the NED in performing his role, in any way. Let us see if we really need NEDs when there are other mechanisms of control like control by market, take-over bids and shareholders.

There is no legal requirement imposed by the Company Law Act of 1985 on the UK listed companies to have a NED. In fact the Company Law Act 1985 does not even distinguish between executive and non-executive directors, but the boards of almost 90% listed companies in UK have a significant proportion of NEDs on board. [5] 

In the 2nd chapter, we will talk about the most famous literature including the landmark reports in context with the role if NEDs in UK listed companies. The next chapter will address the debate on the importance of role of NEDs in the presence of other mechanisms of market control. D we really need them or are they just increasing the burden on shareholders? In the 4rth chapter we will discuss how they perform their essential functions and determine what is the role played by the NEDs, which is going to be the focus point of this paper.

2ND CHAPTER

LITERATURE REVIEW

As it always happens, a big reform is led by a big failure; the same thing happened in the history of corporate governance in UK when such corporate collapses occurred that shook the economies world wide, the researchers and market experts undertook the research to find out the fallacies and came out with some specific reforms. The first and the most important reform of its kind was the report presented by Sir Adrian Cadbury in 1992, which is also the base on which the corporate governance framework of UK’s listed companies rests. So it will be dealt in a bit more detail than the others as it happens to be the masterpiece around which other codes were developed.

The Cadbury report put forward very important measures for reform in corporate governance framework in UK. The reforms in context of the NEDs were very specific and straightforward. As a reaction to the report presented by Sir Adrian Cadbury, the number of NEDs in the market increased many folds. [6] The report very firmly stipulated the requirement of inclusion of NEDs on the boards of all UK based public listed companies. The report further stated that the boards of such companies should comprise of at least a minimum of 3 NEDs. It very clearly stated the importance and role of NEDs in bringing an independent voice [7] , expertise [8] and leadership [9] into the boardroom.

However, Cadbury report addressed the whole issue to a unitary board system whereas having a unitary board on the first hand poses the biggest problem for NEDs in pursuing their monitoring role effectively as it does not encourages shareholder involvement in decision making. [10] That means that even though Cadbury provided the remedy to improve internal mechanism, it did not deal with the structure of the board in UK companies, i.e., the unitary board structure which is the prevalent one in UK against the dual board system in which there are two boards, the executive board headed by the CEO and the supervisory board, comprising of NEDs, headed by the chairman. [11] 

Moreover, Cadbury’s recommendations in context of the role of NEDs were not so clear. It left the debate on the conflicting role of NEDs between monitory and strategic untouched. [12] Till date it is not clear that what are the roles of NEDs or whether there should different set of NEDs on board to undertake theses different functions. If the NEDs are assumed to monitor the executives then it is almost impossible for them to stay independent and monitor at the same time. [13] In fact, Cadbury took a very narrow view of the independence of the NEDs by restricting the definition of independence as just not having any previous relationship with the company, completely ignoring the issue when an independent director is holding the shares of the employee company. [14] 

The next loophole in the masterpiece was related to the number of directors stipulated by Cadbury report. The report said that a minimum of three directors should sit at the board of UK’s listed companies. [15] However it did not balance the number of directors to the size of the board, which happens to be a very important issue in the effectiveness and role of NEDs. If the boards are not balanced with the number of executive and non-executive directors then it is very difficult for the NEDs to state their point and be influential on the board. Moreover, the report did not provide sufficient resources to the NEDs to balance the board. [16] It simply expected the NEDs to balance the board but did not say anything about how they should do it, either by some extra powers or by any other means.

In spite of having so many drawbacks it was still a masterpiece as it introduced the three committees namely the audit committee, nomination committee and the remuneration committee to regulate the accounting, selection and pay of the executive directors respectively by the provision of NEDs. [17] These three committees in themselves gave ample powers to the NEDs as they were to be composed of the NEDs either completely or partially which made them effective in their monitoring role specifically. [18] The major change brought by this was directly in the reduction of agency costs borne by the shareholders as the remuneration of directors was now controlled by the NEDs on one hand but the remuneration of NEDs was an extra addition to the agency cost in an attempt to limit it on the other hand. Therefore its success is still in doubt.

Inspite of all this, Cadbury report was widely adopted by most of the firms. [19] 

Cadbury report was followed by a number of reports like the Greenbury, Hampel &Turnbull reports which tried to further improve the governance structure working on the same principles of Cadbury. [20] One of the most relevant reports out of these was Higgs report on the role and effectiveness of NEDs published in 2003 which was also incorporated in by the combined code of 2003. [21] This report suggested many reforms and covered many loopholes of Cadbury report. For example, it increased the number of directors from 3 to 50% of that of the board. [22] This move was severely criticized in the markets as impractical and over-burdening. [23] However, this was one of the most practical reforms to balance the board of directors by an equal majority of NEDs so that the later could exercise their influence. The report also emphasized on separation of role of CEO from chairman saying that the chairman should head the NEDs whereas the CEO should head the executive directors [24] , although it was also aimed at the unitary board. [25] Higgs report also introduced the requirement of a senior independent director who should indulge in frequent dialogues with the shareholders. [26] The report limited the term of NEDs to a period of 6 years. The report basically followed the guidelines of Cadbury report and Hampel report on the monitoring and supervisory role of NEDs. It further emphasized the crucial role of chairman in creating better working conditions for the NEDs so that the later do not face a lack of information because of being part-time. [27] It also stated that the chairman of the company should also be an independent executive and not a previous employee or shareholder. [28] The review also gave a new definition of independence of the directors which was indeed much broader than the one given in Cadbury report but still it failed to include the ‘mental independence factor’ rather than the independence of just the actions of NEDs. [29] However the main drawback of the report was that it saw the role of monitoring role and creating accountability in the board room as a complementary role. [30] Moreover, the review even after adopting very drastic and hard changes, adopted the same ‘comply or explain’ approach, rather we should say ‘comply or escape’ approach. [31] Similar to the previous reports, even Higgs review left the confusion on the role of NED as such, without clearing whether the NEDs should control & monitor on behalf of the investors or whether they should support the executives in framing strategies. [32] This debate is very beautifully addressed by some researchers. [33] On the other hand, many scholars and researchers strongly believe in the importance of monitoring role of NEDs. [34] NEDs are widely seen by many scholars as a tool to limit the agency costs in companies which have widely dispersed shareholdings. [35] The review presented by Derek Higgs was based on some studies one of which was conducted by Roberts, MC Nulty and Stiles who emphasized on the behavioral patterns as an important factor in determining boardroom dynamics. [36] 

CHAPTER 3

NEED OF NEDs IN CORPORATE ECONOMY:

WHY ARE THEY SO IMPORTANT? A POSITIVE VIEW

Since the separation of ownership from control, the ‘governance’ of a firm has remained an issue of great concern as it gave rise to a situation where the controllers (executives) certainly had no similar financial incentives as the manager-owners to increase the value of the firm. [37] Other than NEDs there are mainly three more mechanisms for control:

Control exercised by shareholders.

Control exercised by market.

Control exercised by the intervention of court.

All of them suffer from huge drawbacks. Let us have a look on these for a better understanding of the importance of such an expensive tool like the NEDs.

SHAREHOLDERS:

Although they are given ample of rights and protections like voting, meetings, AGMs etc. because they are the actual owners of the wealth; they are never at the same footing as that of the insiders like executives, directors, employees & managers who have access to the price sensitive information. [38] This difference in position creates an information asymmetry which is then exploited by the insiders who have a better access to the information than the outsiders (shareholders). [39] This is one of the major fallacies of the market which can be corrected by the monitoring role of independent and impartial NEDs as they have an equal footing as that of the insiders by their access to information and hence can make the markets more transparent. [40] 

The other disadvantage suffered by the shareholders is that they have widely dispersed holdings which makes it very costly for them to exercise control over the executives giving the later a chance of escape from their duties & liabilities. [41] 

Also, the shareholders will always lack the incentive to monitor. As the benefits of monitoring would be outweighed by cost when a small group of shareholders will be struggling for their rights and the resultant profit will be evenly distributed among the widely dispersed shareholders who would be riding free of cost on the benefits earned by this small and active shareholders group. [42] 

The situation is different if the shareholdings are concentrated like they are in UK, the majority shareholdings are vested with institutional investor companies like LIC or pension fund holdings. There are two problems which renders the exercise of control by shareholder ineffective:

1.1 These financial institutions acting as major stock holder are in turn controlled by such unscrupulous managers and executives who are least bothered about the rights and protection of the actual shareholders (people who have invested in these financial institutions). [43] 

Also, these shareholders have a better and more cost effective way out than being active, i.e, exercising the ‘exit’ option whenever they are unsatisfied with the performance of the firm, considering the fact that UK’s secondary market is highly liquid for corporate securities due to heavy trading and suffers information asymmetry problem. [44] 

Given the ineffectiveness of shareholders as a mechanism of corporate control, lets consider the other mechanisms.

MARKET:

The market can exercise control by take-over bids where the management of badly performing companies is ousted out by a take-over and is replaced by other management. The executives are expected to be controlled as they would be under constant fear of being ousted out in the case of poor performance. However, this situation acts as a control at the time when the firm is already on the verge of collapse. This happens to be a very expensive and uneconomical way to control the management. Hence even this mechanism is also of limited effectiveness. [45] 

INTERVENTION BY COURTS

The next mechanism is the intervention by courts by attaching more rigorous liability to the executives. [46] However this is severely criticized by market theorists who say that market imposes discipline sufficient enough to secure efficient management. [47] They say that increasing liability adversely affects the willingness of directors to take risks. [48] Our aim should not be eradicating inefficiency, but regulating the costs of these inefficiencies in accordance with the costs of the solution so that the wastage of resources and time is minimal, not zero.

In the present situation, if the shareholders are neither interested nor effective in controlling the vast powers of executives, and all the other mechanisms have limited influence on managerial entrenchment, the management has no hindrance in exercising their discretionary powers in the pursuit of their self- interest [49] . Clearly, all these mechanisms are rendered ineffective in the exercise of control. [50] This gives rise to a very strong institution which should suffer neither from information asymmetry nor from any self interest, something that acts like an independent & accountable watchdog in this scenario where everyone is indulged in self-service. Moreover the two separate functions of decision management and decision control should be undertaken by two distinct groups, independent of each other. [51] The decision management and strategic planning should be taken up by the salaried executives, who also have direct access to all the information and the decision and the decision control & ratification should be done by executives who are elected by and are in better contact with the shareholders (residual claimants). [52] In order to be cost effective and justified in the economic efficiency argument of Fama & Jensen, these pupil should be completely independent of the executives & well informed at the same time, having direct access to the information. [53] If we see this argument under an agency theory lens, it is clear that the institution of NED is devised to target some specific objectives. This establishes the need of NEDs in performing the role of an independent and impartial monitor who has the capacity to deal with the sensitivity of the issue.

Consequently, there are arguments in favor of effectiveness of NEDs which say that the NEDs cannot afford to take their responsibilities in a for granted way as it affects their reputation which is directly associated with their worth in the market. [54] This means that the handsome package that a NED would get is simply based on his smart work, the worth of which he has proved in previous companies and firms. Not only this, also if a NED performs poor in a company, he finds it difficult to get further appointment in a new company. [55] A study has further found out that the executives of well performing companies are more in demand in the market as NEDs of other companies. [56] 

However, the instances of executives of well performing firms holding the position as a NED of other form are very low as it potentially affects the performance of executives adversely. [57] Therefore NEDs interested in creating a separate and sincere profession of NEDs as a diligent monitor, work sincerely to assure that. [58] 

Let us examine a case study for understanding of role of NEDs and its impact on a firm’s performance and reputation in the market.

CASE STUDY: Marks & Spencer Plc. [59] 

The firm had a very good and consistent performance for a number of years but lately suffered ill health in terms of market value as well as profits in 2000-2002. When the reason behind this was analyzed, it was find out that the company had very poor corporate governance and was in fact breaching all the principles of good governance but it was curtained under the huge profits the firm had been earning from past few years. The loopholes in its corporate governance came into spotlight only when its sales and profits fell steeply. Few of the issues in the report, which are relevant to this paper, were that it lacked sufficient number of NEDs on its board causing imbalance at board level, the board was dominated by a gang of old executives and directors & no board committees (remuneration, audit & nomination) were present.

It took two years for Marks & Spencer’s to reconstitute its board of directors. [60] It appointed Jack Keenan & Paul Myners as the new NEDs for their expertise and knowledge in the business. [61] The main board committees like audit, remuneration & nomination committees were also formed. [62] The firm has now regained its name and confidence in the market and is now doing well after the reconstitution.

Let us see how this institution of NEDs effectively manages to balance the market on both ends by the wide spectrum of its roles in the coming chapter.

CHAPTER 4:

ROLE OF NEDs

The NEDs are considered as the mainstay of corporate governance. [63] The Combined code stated that the NEDs are responsible for balancing the board of directors. They act as a counterweight on the board so that no particular group can dominate the decisions of board. [64] This balancing role of NEDs assures effective corporate governance to a great extend as they act as a resource of valuable information to the company on one hand, whereas the executive directors would provide their objectivity and in-depth understanding of the issues on the other hand. [65] This mixture would provide a powerful tool for good corporate governance. The role of NEDs is multifaceted and multi dimensional in UK listed companies. They are entrusted with a bunch of responsibilities like monitoring, providing expertise on specific areas, providing strategic direction, board valuation regarding to the issues of appointment & removal of management and many more. [66] The main role of NEDs in UK listed firms include strategic as well as management functions, information disclosure and keeping a keen eye on the governance issues. [67] 

One of the special attributes to the role of NEDs in a firm is to their vision. [68] It is compared to the ageing process where if you see yourself in the mirror everyday in the mirror, you cant notice the signs of ageing, just like the inside directors who are working with the firm from past couple of decades, seeing the firm changing and developing bits by bits; whereas if you see yourself in the mirror once in ten years, you’ll instantly find the change, just like the outside directors who have a supervisory vision to catch up even the most common and minutest flaws in the structure or performance of the company. [69] NEDs act as an asset to the company and a reservoir of resources. They bring in new resources like expertise in a specific area, advising the NEDs , bringing in new contact , contributing and providing a strategic direction by bringing in an outsiders’ perspective. [70] The hypothesis from last argument of previous chapter suggests that the following should be the areas of scope of the role performed by NEDs in a company:

Minimizing the agency costs

Controlling and monitoring the highly potential powers of executives.

Directing the firm to fulfill its aim of economic efficiency and social welfare.

Stabilizing the position of not only the shareholders but also the investors and creditors with that of the executives.

However the Higgs report attached some additional criteria to the NEDs like integrity, high ethical standards, strong interpersonal skills, sound judgment and the capability to understand and probe into issues. [71] It has been suggested that one of the main role of NEDs should be creating accountability in the board room. [72] Accountability does not mean calling for account, rather it means to encourage dialogue & openness in the board room and not concentrating merely on justifications. [73] This would result into open discussion of the plans, strategy & schemes generating higher levels of understanding. However, it would be incorrect to presume that the same approach will suit all the boards but there are some particular approaches which shape up the role of NEDs.

The Cadbury report pointed out that the caliber of NEDs is of special importance in setting and maintaining good standards of corporate governance. [74] If we the sum up the situation under an agency theory perspective, the most prominent and important role of NEDs derived from it should be monitoring the board of directors. It happens to be the most important as well as the most problematic role of the NEDs given the resistance of management to surrender their monopoly and autonomy. [75] For this reason the monitoring role deserves special attention, the same has been discussed in more detail in the following section.

MONITORING ROLE OF NEDs:

The essence of monitoring is not in attaining a flawless audit or perfect internal control, but it is in the assurance that the board is very well under the control of situation. [76] 

The monitoring role aims at reducing the agency costs borne by the shareholders by aligning the interests of shareholders with that of the company management. [77] It is the strong governance control exercised by the NEDs. [78] The literature offers a very strong support in favour of the monitoring role of the board. [79] Monitoring by NEDs is actually a process whereby the performance of management is often subjected to NEDs scrutiny and review and if necessary the NED takes the step of removing the senior management if it is not performing well or contributing negligibly to the running of the business. [80] Therefore, this function offers a way of overcoming managerial entrenchment as it plays part in controlling issues like improper insider dealing and prevents adoption of growth and development strategies which are beneficial to the management but detrimental to the interest of shareholders. [81] A study conducted by Milstein & Mac Avoy suggests that the monitoring by an active group of independent NEDs on board improves the performance of the firm many folds. [82] 

Moreover, what makes monitoring so effective is the fact that the NEDs have this presumed unlimited access to the sensitive information of the company which the other mechanisms of monitoring like shareholders and other outsiders do not have. [83] Also, monitoring by board avoids costs associated with takeovers in the form of bid-premiums and transaction costs that significantly blunt their disciplinary effect. [84] 

The other side of story: CRITICISM AGAINST THE NEDs

A lot has been said and written in favor of NEDs but it looks true and promising in literature only. The practicality of corporate world and the dynamics inside the board room is a contradiction to the belief of NEDs as an effective part of corporate governance. [85] This part of the paper tries to explore the realities so as to balance the both sides of the argument because it will be incorrect to decide on the basis of one side of the story. In UK a separate supervisory board is not common, so the single/unitary board has to act in all directions. [86] The success of the board depends on many factors like the structure of the board etc. [87] Therefore despite the presence of NEDs the inside directors and executives dominate the board. [88] Out of 1,612 UK listed commercial & industrial companies, 63% of companies have majority NEDs who are full time executives of other companies. [89] It is worth giving a thought that how much hours in a week could be given by these full time executives to their NED role? Moreover, the ratio of executives to NEDs is 2:1 in these companies and most of the NEDs who are not full time executives, are retired directors belonging to the same group. [90] Moreover, these NEDs certainly lack incentives to fulfill these challenging and committing roles. [91] 

Let us start with the first argument which challenges the very need of NEDs on board.

1ST Argument: Why do we need NEDs as NEDs if they have a better vision than the executives? Why don’t we directly appoint them as full –time executives instead?

If outside directors are effective in removing the poorly performing executive directors then the later would be under a constant pressure to perform well. But this leads us to think & analyze whether our NEDs are really removing the poorly performing executives?

Evidence show that in UK the NEDs are not doing what they are expected to do. The fact is that the NEDs are not performing accordingly because of which there is no pressure on the full-time executives to perform well. [92] 


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