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One of the main suggestions in these reforms concerns the presence of independent directors on the board of directors. But to what extent independent directors contribute to effective corporate governance is highly arguable. Do they strengthen the board? The views about it seem to be highly contradictory.
It has been ever claimed that independent directors are boardroom intruders to be tolerated for the sake of compliance. (Iwu-Egwuonwu 2010)
The views in the literature concerning the roles and contribution of independent directors vary to different degrees.
The purpose of this chapter is to point out some of the available literatures on the roles and contribution of the independent directors.
The emphasis on the presence of independent directors on the board derives mainly from corporate governance practices. So, any discussion or review of literature on the subject matter will take its bearing from a brief introduction of corporate governance.
The corporate governance practices are well established since a very long time; Adam Smith in the eighteenth century demonstrated it in his statement:
"The directors of companies, being managers of other people's money than their own, it cannot be well expected that they should watch over it with the same anxious, vigilance with which partners in a private co-partner frequently watch over their own" (Smith, 1776).
The concept of corporate governance then spurred from the pre-1992 American discussions, the Cadbury Report, Turnbull Code, the Organisation for Economic and Cooperative Development principles (OECD, 1998 & 1999) and the Sarbanes & Oxley Act. Though there have been numerous debate about corporate governance, the proponents have not yet settled on any universally accepted definition.
In its simplest definition, corporate governance is a system by which corporations are governed and controlled with a view to increasing shareholder value and meeting the expectations of other stakeholders. (Iwu-Egwuonwu 2010)
The OECD provides a functional definition of corporate governance:
"Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined" (OECD 1999).
OECD's definition is consistent with the one presented by Cadbury (1992), "Corporate Governance is concerned with holding the balance between economic and social goals, and between individual and communal goals with the aim to align as nearly as possible the interests of individuals, corporations and society".
The Guardian (2010) explains that ''â€¦ the simple idea of corporate governance is about building confidence in your product erected on the foundation of transparency and accountability; good corporate governance flowed from practices that involved fairness, accountability, responsibility and transparency on a foundation of intellectual honestyâ€¦''
The concept of corporate governance embraces:
Legal & regulatory systems
Banking regulations and practice
Consistent accounting and auditing standards
Properly regulated capital markets
Effective oversight by corporate boards and recognition of the rights of minority shareholders.
Corporate Governance and Banking
Bank governance has been the topic of much recent academic work and policy discussion (Senior Supervisors Group 2008, 2009; Walker Report 2009; Committee of European Banking Supervisors 2010).
The corporate governance of banks is crucial, for banks are key players in the economy's financial system, and are important engines of economic growth. With the deregulation of the banking sector, regulation has become more relaxed and consequently management of banks have greater freedom as to how to run the business (King and Levine 1993a, b; Levine 1997). Banks are both opaque and complex. As Levine (2004) notes, "Banks can alter the risk composition of their assets more quickly than most nonfinancial industries, and banks can readily hide problems by extending loans to clients that cannot service previous debt obligations."
Still banks are subject to corporate governance rules, regulations, and policies issued by the regulatory agencies and are subject to regular supervisory review of their corporate governance practices and procedures. Macey and O'Hara (2003) argue that a broader view of corporate governance should be adopted in the case of banking institutions and also stressed that the scope of the duties and obligations of bank directors and officers should cover the soundness and safety of banks.
Because of the bank's special position of trust in the national economy, their corporate governance is a matter of extreme significance. Banks are highly leveraged institution, with most of their funds coming from depositors and creditors. They provide services to the public, financing to commercial enterprise, and across to the payment system. Increasing globalization of the financial market, emergence of conglomerate structures, technological advances and innovations in financial products have added to the complexity of risk management in the banking sector. For these reasons, the quality of corporate governance expected of banks is high. (Bank of Mauritius, April 2001).
The rationale for Independent Director
To counteract the agency problem
It is often claimed that the standard definition of corporate governance stems from the agency theory.
Berle and Means (1932) are generally recognised as the pioneers in thinking about corporate governance. During the second half of the nineteenth century in US, the outlook of companies being considered as private property faded and gave way to professional managers controlling more and more the business while the shareholders became widely scattered while they enjoy the benefits of limited liability. This has been termed as "the separation of ownership and control".
According to most academic literature, this separation of ownership gives way to the "agency" problems which is the root cause for governance problems. When shareholders (usually known as the principals) delegate decision making authority to the management (the agents), an agency relationship is said to exist between the two parties.
As residual claimants on the firm's income stream, shareholders want their agents - the firm's managers - to maximise wealth. Because managers cannot capture all of the gains if they are successful, and will not suffer all of the losses should the venture flop, they have less incentive to maximise wealth than if they themselves were the principals. Rather, managers have an incentive to consume excess leisure, perquisites and in general be less dedicated to the goal of wealth maximisation than they would be if they were not simply agents (Fischel 1982).
Sheng (2000) admits that an important theme of corporate governance is to ensure the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent problem. This accountability is presumed to be more properly and adequately rendered by a board comprising of a majority or supermajority independent directors.
As such, the use of independent directors to monitor the performance of the executive management is one element of a broader tapestry of monitoring devices and rules which serve to reduce the divergence between the interests of shareholders and management ("agency costs").
In other words those who advocate an increase in the proportion of independent directors on company boards are implicitly, if not explicitly, suggesting that such a development would bring about a net reduction in agency costs.
Agency costs comprise (i) the costs incurred by shareholders in monitoring managers in order to minimise the divergence between their interests; (ii) "bonding" costs incurred by managers; and (iii) the residual loss resulting from the remaining divergence in shareholders' and managers' interests (Jensen and Meckling 1976).
The various bodies promoting independent directors through their corporate governance guidelines adopt this agency-cost rationale for independent directors, although some do so more explicitly than others. For instance, the Cadbury Committee (1992, paras 4.4-4.6) considers the usefulness of independent directors as follows:
"Non-executive directors have two particularly important contributions to make to the governance process as a consequence of their independence from executive responsibility. â€¦ The first is in reviewing the performance of the board and of the executive. â€¦ The second is in taking the lead where potential conflicts of interest arise. An important aspect of effective corporate governance is the recognition that the specific interests of the executive management and the wider interests of the company may at times diverge, for example over takeovers, boardroom succession, or directors' pay. Independent non-executive directors, whose interests are less directly affected, are well-placed to help to resolve such situations."
Similarly, the OECD's corporate governance guidelines (OECD 1999) state:
"Independent board members can contribute significantly to the decision-making of the board. They can bring an objective view to the evaluation of the performance of the board and management. In addition, they can play an important role in areas where the interests of management, the company and shareholders may diverge such as executive remuneration, succession planning, changes of corporate control, take-over defences, large acquisitions and the audit function".
Contribute greatly to the company
Independent directors are considered to carry with them a number of advantages, including independence in their views and the ability to bring an outside perspective into the board meetings. Furthermore, as their primary function is to comment on corporate strategy and to direct general policy and overall supervision of the company, they can help to provide effective leadership.
The presence of independent directors serves in bringing about impartiality in the board as a whole. Such impartiality effectively means that considered advice would be provided and developed for the purposes of steering the company strategy as a whole by the board of directors. It is a fact that whilst independent impartial advice can also come from the professional advisers appointed by the board, including financial and legal advisers, however, the independent director's role goes further. He is, for one, able to directly contribute and possibly shape the discussions of the board.Â
Guidelines on Board Composition
Board composition is one of the main features of corporate governance debate. Practically all corporate governance guiding principle discuss about board composition. There is suggestion that the board and various board committees such as audit committee, remuneration committee and nomination committee be comprised of a minimum number of independent non-executive directors. An active, well-informed and independent board is necessary to ensure the highest standards of corporate governance.
The board should have an appropriate balance of executive, non-executive and independent directors under the firm and objective leadership of a chairperson to ensure satisfactory performance within a framework of good governance to serve the interests of all stakeholders of the company. (The code of corporate governance for Mauritius, 2004)
Every board of directors must think about the balance desired for its composition and effectiveness of its organisation and its operations in the performance of its tasks. Boards should include non-executives of sufficient calibre and members for their views to carry sufficient weight in the board's decisions.
AIMA (1997) (Australia)
a majority of board members should be independent nonexecutive directors
Bosch Committee (1995) (Australia)
a majority of board members should be non-executive
at least one-third of board members should be independent non-executive directors
London Stock Exchange (1998) (UK)
at least one-third of board members should be non-executive
a majority of the non-executive directors should be independent
a substantial majority of a board's members should be independent directors
Business Roundtable (1997) (US)
a substantial majority of directors should be outside (non management) directors
American Law Institute (1994) (US)
boards should be composed of a majority of independent directors
CalPERS (1998) (US)
a substantial majority of the board should consist of directors who are independent
as a matter of policy there should be a majority of independent directors on the GM board
the board of directors of every corporation should be
constituted with a majority of individuals who qualify as unrelated (independent) directors
the boards of all listed companies should have at least two independent members
boards shall consist of sufficient independent directors to influence the conduct of the board as a whole
in order for boards to effectively fulfil their responsibilities they must have some degree of independence from management
SOURCE: Laurence and Stapledon- Do Independent directors add value
Concept of independence and independent judgement
Independence is not a static phenomenon. Like everything it tends to evolve according to the climate, environment, attitudes, ability and age. It has been generally proclaimed that independence is a state of mind, free from material conflicts, ability to exercise objective judgement. As such independence is a highly subjective notion.
The literature recognises the difficulty of assessing the independent judgement. The relationship between independent directors has been rather termed as complex. However, in theory independent judgement is vital for effective contribution (McNulty et al. 2002).
Typically, corporate governance codes and stock exchange listing rules call for independent outside (non-executive) directors to play a vital role in the unitary board. Independence is precisely defined to ensure that these directors have no interest in the company that could adversely affect genuine independent and objective judgement.
The definition of independence in most corporate governance codes is exhaustive. To be considered independent a director must have no relationship with any firm in the up-stream or down-stream added-value chains, must not have previously been an employee of the company, nor be a nominee for a shareholder or any other supplier of finance to the company. Indeed, the definition of independence is so strict that an independent director who has served on the board for a long period is often assumed to have become close to the company and is no longer considered independent.
A dilemma arises here; the more independent the directors are, the less they are likely to know about the company, its business and its industry. Conversely, the more directors know about the company's business, organization, strategies, markets, competitors, and technologies, the less independent they become. Yet such people are exactly what top management needs to contribute to its strategy, policy making and enterprise risk assessment.
This argument looks set to run a long way.
(Bob Tricker 6 December 2010)
Directors could be independent by definition only but may not be so in practice. Companies may be complying for the sake of compliance. In regards to reinforcing board independence, the recent codes adopt a two-fold approach. There is a requirement for increasing the number of independent directors and a more extensive and restrictive definition of independence.
Prior literature on roles and contribution of independent directors
The non-executive director is described as that of a long-term, consensus-based decision-maker (Tricker, 1978; Pro Ned 1992) and as a custodian of the governance process (Higgs, 2003).
The literature indicates that the involvement and effectiveness of independent directors may vary considerably partly due to contingent factors such as ownership structure and the power between internal and external stakeholders which affect the composition and function of the board.
Act as monitor and/or advisor
Prior literature, both theoretical and empirical, has focused on one of many facets of the board of directors as a monitor or/and as an advisor. Notably, non-executive directors are perceived as significant long term and impartial decision-makers and monitors of the governance process (Tricker 1978; Higgs 2003).
For several reasons outside independent directors have been seen as the most able to assume both roles inside the board. First, outside independent directors are not (or less) subject to potential conflict of interest that reduce their monitoring capacity. In any firm the final decisions on crucial issues such as setting executive compensation or searching for replacements of top managers are strictly the board authority and in most cases in the hands of independent directors. Second, outside directors are in most cases experienced professionals or key persons in other firms or large organizations who care about their reputation. Fama and Jensen (1983) hypothesize that this reputation effect, not large compensation, induces outside directors to monitor. Third, outside independent directors possess technical expertise both in management and decision-making which allow them to be effective monitors (Fama and Jensen 1983), or to influence firm financing policies (Guner, Malmendier and Tate 2006). Fourth, as their careers are not tied to the firm's CEO, outside directors can defy the CEO's decision if they think it is not in the interest of the shareholders. This in a way builds their reputation as superior monitors and as a result they can obtain additional director appointments.
There has been abundant evidence that outsider-dominated boards are better monitors. Fich and Shivdasani (2006) went further in specifying that independent directors and boards can only be good monitors if they are not "too busy". They found evidence that firms in which a majority of outside directors accumulate three or more directorships are associated with weak corporate governance. Markets react positively when a busy outside director leaves, and negatively when a director becomes busy by accepting and additional directorship.
Acts as a factor that increases/decreases the value of the firm
Many previous papers show that independent directors are not value increasing (Bhaghat and Black (1999, 2002), Hermalin and Weisbach (1991), Klein (1998), or even value-decreasing (Agrawal and Knoeber (1996)). One exception is Rosenstein and Wyatt (1990) who showed that stock price positively reacts to the nomination of independent directors to the board. However, as pointed out by Hermalin and Weisbach (2003), the positive market reaction could be driven by the need for change rather than the contribution of independence. Indeed, in a follow-up study Rosenstein and Wyatt (1997) found similar effects for nomination of insiders. Perry and Peyer (2005) showed that in some circumstances, outside directors who accumulate multiple directorships enhance firm value.
Effective board requires capable individuals of high status (Ward, 1998) who are able to contribute to the company experience, financial expertise and credibility with shareholders (Samuel et al, 1996).
. Contribution to corporate performance
Adams and Mehran (2010) find that bank performance is unrelated to the outside director ratio.
Then there is the study of Agrawal and Knoeber (1996), which showed that the greater the proportion of independent directors, the slower the company's growth. Agrawal and Knoeber interpreted their results as evidence that board independence is negatively related to company performance. However, the results of the Agrawal and Knoeber study are also explicable on the basis that a high proportion of independent directors were a response to slower growth rather than the cause of the slower growth (Bhagat and Black 1997). Indeed, the study by
Hermalin and Weisbach (1991) showed that the proportion of independent directors tended to increase when a company performed poorly.
Another study of 100 small listed US companies revealed that financial performance was better in companies with relatively large number of independent directors than in those having a relatively small number of independent directors (Daily and Dalton 1992).
Still dwelling on whether independent directors produce superior performance for firms, and value for shareholders, Choi et al. (2007) report that the effects of independent outside directors on firm performance are strongly positive.
Caselli et al., (2008), concluded their research by stating that independent directors certainly do not improve performance in these firms, although the skills of individual directors can be useful in board activities, especially with respect to deals on the front burner.
Strengthen corporate board
A study by Steven T. Petra (2005) on whether independent directors strengthen boards in regards to Board Composition, CEO duality, audit Committee, compensation Committee and nomination Committee revealed that outside directors do appear to strengthen corporate boards. However, more needs to be done to change the environment in which corporate boards operate and to re-establish market's confidence in the corporation's ability to effectively govern itself.
Emphasis is laid on independent directors to have the right attitude. In order to achieve this, three conditions need to be jointly fulfilled. These are the ability and the willingness to be a critical thinker with an independent mind and the environment should be there to facilitate the display of this attitude. Different types and rules of board's structure will therefore have different impact on effectiveness.
Empirical Research Studies on Independent Directors in strengthening Corporate Boards: Source: Steven T. Petra - Do outside independent directors strengthen corporate board
OUTSIDE INDEPENDENT DIRECTORS DO STRENGTHEN CORPORATE BOARDS
OUTSIDE INDEPENDENT DIRECTORS DO NOT STRENGTHEN CORPORATE BOARDS
Carcello and Neal (2000)
Shivsadani and Yermack (1998)
Cyert et al. (1997)
Grace et al. (1995)
Deeshow et al. (1996)
Hermalin and Weisbach (1991)
Barnhart et al. (1994)
Daily and Dalton (1992)
Byrd and Hickman (1992)
Schellenger et al. (1989)
Act as control mechanism
Weisbach (1988) reported that, a board composed of at least 60% independent directors was more likely than a board comprising less than 60% independent directors to dismiss an underperforming company's CEO.
The existence of truly independent directors acts as a big deterrent for managers from pursuing self serving goals (bhasa, 2004).
An accepted role of independent directors is the removal or disciplining the CEO of an under-performing company (Bosch Committee, 1995).
As Johnson, Daily, and Ellstrand (1996) pointed out, directors have multiple roles in addition to a monitoring role. Outside directors can play an advisory role to the management in volatile or vulnerable corporate environments or they can act as a facilitator in resource expanding activities or dealing with outside organizations.
Significantly, independent directors are viewed as people who can provide a better quality and assurance of reasoned corporate judgement (Ferris, Jagannathan & Pritchard 2003). Whilst managers, who have to face the pressures of day-to-day events, may overlook some of the decisions made and/or avoid making risky choices (Firstenberg & Malkiel 1980). Nevertheless, having general wisdom is not enough for independent directors to contribute productively. They need to be competent and capable of understanding the firm's business operations (Gupta, Otley & Young 2008; Lessing 2009; Delgado-Garcia, de Quevedo-Puente & de la Fuente-Sabaté 2010).
The studies above have produced mixed results as to the contributions and roles of independent directors. Therefore, it is highly debatable as to what extent independent directors do justice to their responsibilities.
Mauritius has also got its own Code of Corporate Governance which was issued, by the committee for corporate governance under the auspices of Ministry of Industry, financial services and corporate affairs, 9 years ago that is more specifically in October 2003.
This code has designated the institutions which must comply with it and among them is found the banks and non-banking financial institutions:
"All such companies shall comply with all the provisions of the Code.
The Bank of Mauritius and Financial Service Commission may further require that certain provisions of the Code be mandatory ... regulation."
The Code became mandatory as from July 2009. It requires all public interest entities including banks, nonbank financial institutions and listed companies to ensure compliance or else to provide explanation("Comply or Explain" basis) for not adopting / adhering to any of the provisions of 'the Code' in their financial statements or reports.
In 2009, the National Committee for Corporate Governance (NCCG) commissioned a survey on the state of compliance with the Code of Corporate Governance for Mauritius. This survey found that compliance was inconsistent and illustrated that compliance with the Code of Corporate Governance is still not the norm in Mauritius, in that only 30% of the companies state that they currently comply with the Code, 29% do not comply. A certain note of indifference for the matter was observed among companies, as denoted by the level of non-response to the survey [41%]
Higher compliance with the Code is noted among listed companies [including Banks and Non-Banking Financial Institutions] [83%] and State Owned Enterprises [44%], rather than among DEM Listed companies [36%] and non-listed companies [9%]
While in most cases [86%], companies seem to respect the Code by appointing an Independent / Non- Executive Director as Chairman, qualitative research reveals that, some Audit Committee members often lack knowledge of the business operations/competency to be really of value added. (DCDM 2009)
This chapter has been oriented towards the views of independent directors on the literature and the next section the methodology.