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Importance of the Board of Directors to the Corporate Governance of Large Listed UK Firms

Info: 3287 words (13 pages) Essay
Published: 23rd Mar 2021 in Finance

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 According to the Organization for Economic Cooperation (OECD), the corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders (G20/OECD Principles of Corporate Governance 2015, 2015), meaning that the board has both executive and monitoring capacities and must act in such manner to fulfil the shareholder’s interest, that is “the maximization of current value per share of the existing stock” (Jordan, 2019). Moreover, in order to analyze the importance of the board of the directors a summary of the duties and pre-requisites for the Directors that compose the board is needed. The legislation of the United Kingdom enumerates the following duties owed by a director: “Duty to act within powers” (Companies Act 2006), which translates into the obligation to obey the company’s constitution and to only manifest its powers according to its development; “Duty to promote the success of the company”(Companies Act 2006), meaning that the director must facilitate the company’s evolution, for the benefit of the shareholders and employees, by taking in consideration any long-term consequences of each decision; ”the duty to declare interest in proposed transaction or arrangement”(Companies Act 2006), that obligates the directors to communicate any transaction proposal, which shall be voted at a meeting of directors and also the “duty to exercise reasonable care, skill and diligence” (Companies Act 2006), that resorts to the overall competence, and experience of the person carrying out the function.

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Overall, the legal framework presented before highlights the responsibilities of members of a board of directors, which assures an overall objectivity in the actions taken by its members, having into account the good development of a company, thus the importance of the board of directors lies in its position to monitor the activity and evolution of an entity and therefore making decisions accordingly, without any third-party interference.

   Firstly, the main advantage of the board of directors is the assured transparency and the consideration of all external factors in the decision-making of the company, facilitated by a diverse composition of the board, from the perspective of the member’s experience, skill and equity involvement. This might be at first a good metric for choosing members of the board, but it is not the determinant factor, “as many board members have the training and smarts to detect problems and somehow fail to do their jobs anyway” (Sonnenfeld, 2002a). A good example to sustain the argument is the bankruptcy of the world’s oldest travel agency, Thomas Cook, that took place on September 23rd, after facing financial trouble for several years. According to The Economist, the main cause for its demise is the company’s business decisions can be traced back to 2007, “when it merged with MyTravel Group plc, followed by an ill-judged series of takeovers added to it, leading to a £3.1bn hole in its balance-sheet” (Anon, 2019) in its attempt to gain competitive edge against the so-called “New online-only travel agents” (Anon, 2019). Back then, according to the company’s annual report, the Chairman was Dr Thomas Middelhoff, who was also a chairman of Arcandor AG, denoting vast experience in corporate management.

On the other spectrum, we can find JD Fashion Sports, one of the best-performing stocks in 2019 on the FTSE 100 index, registering a 68% increase in its share price during the first half of the year, as a result of the £400 million purchase of Finish Line, increasing JD’s presence on the global market, whose Chairman, Peter Cowgill, also an experienced corporate manager, stated in an interview that another factor that made the performance possible was the fact that “the business has stayed very much in tune with the millennials and Generation Z.”. Furthermore, a Survey by Yale School of Management and Gallup Organization reveals that “a quarter of major US business leaders claim that their boards do not fully understand the complexity of their firm's business” (Sonnenfeld, 2002b), meaning that the key to an effective Board of Directors is the thorough understanding of the business by those that comprise it. Therefore, the board of directors, through its structure, is of utmost importance to the corporate governance framework, as it allows for continuous changes in its structure, being an extension of the shareholder’s will, which elects its members through the practice of voting, where each vote has a proportional value to the shareholder’s number of shares owned.

   Secondly, a corporation is considered “a distinct legal entity owned by one or more individuals” (Jordan, 2019), whose liability is limited to the amount invested by a shareholder, meaning that in the case of bankruptcy the shareholders lose the whole investment and vice versa in the case of growth, consequently underlining the importance of the board of directors, as being the entity designated to regulate the company’s cash flow in such way to benefit the investors in the

long-term, action encapsulated in “the duty to promote the success of the company” (Companies Act 2006). For instance, a good example might be the case of Vodafone plc, whose board decided to cut dividends after its stock prices fell 15% after the first half of the year, as a result of the investments made into the 5G spectrum network. On the other hand, we can observe the case of NEXT plc, which reported a 40% surge in the stock price, that “lead to an increase in dividend payment at the end of 2019, while also allowing for the completion of another stock buy-back” (Evans, 2019), which shall increase company’s overall value.

Both cases show us the reaction of the Board Members to different market trends, either positive or negative. It is indeed an arbitrary judgement whether the Board of Directors is reliable for negative or positive outcomes, for this reason, the member is “usually tied to financial performance in general and oftentimes to share value in particular” (Jordan, 2019). The overall agency relation underlined before might be liable to agency problems, because the directors might have the incentive to hyperinflate profit, to raise stock prices for personal gain, which is a clear breach of the “duty to exercise independent judgement” (Companies Act 2006). A real-world example for this case would be the case of Tesco plc, whose former executives were accused of overstating the profits by £250m “intensifying pressure on the board of the supermarket group as it issued its third profit warning in three months” (Anon, 2014). In these particular situations, the Corporate Governance Framework values prioritize the financial safety of the shareholders, by holding the director financially liable for any wrongdoing. For instance, in case of bankruptcy caused by the deliberate actions of a member against a company's financial well-being, an interim bankruptcy board is formed in order to reduce shareholder liability.

This hypothetical example might be a bit on the extreme side, but overall, the importance of the Board of Directors lies in the fact that it has a representative role for the shareholder because with an increasing number of shareholders, each opinion cannot be accounted and held liable for, as well as the financial dependence on the success of the company might impede one’s decision-making, by raising the grade of subjectivity.

Another important attribute of the Board of Directors is that it acts as a safeguard for the shareholder, by not holding them liable for any breach of law.

   In conclusion, the board of directors is of utmost importance to the corporate governance of large listed UK firms, because it ensures sound strategic guidance and monitoring for the corporation, by respecting the company’s vision outlined in its constitution, in order to provide the optimum decision-making for the members needed to maximize shareholder’s value. Further, the Board of Directors also assures a greater grade of objectivity amongst executive members, while also being a consensus for a numerous group of shareholders’ in order to fulfil each one’s vision for the company to the greatest extent. The board of directors also acts as a safeguard, from a legal point of view, for the investor, while also trying to obtain the best financial outcome.

Finally, the board of directors also provides a better organizational framework, by allowing the shareholders to tailor the board of the company, through a vote, to the corporation’s needs and ultimately their need, so that the board becomes an extension of the shareholder, by minimizing and the management process.

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‘We can define corporate governance as the collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders’ (Larcker and Tayan, 2011). It basically refers to the manner a company is led and towards what objective. In order to assure the good and ethical functionality of a firm a monitory system is put in place which mainly consists of the board of directors and an external auditor. The two bodies are responsible for the supervision of the management and the honesty of the official financial statements. This implies that the board of directors and the external auditor have an influence on the corporate governance. However, ‘governance systems are influenced by a much broader group of constituents, including owners of the firm, creditors, labour unions, customers, suppliers, investment analysts, the media, and regulators’ (Larcker and Tayan, 2011). It is also important to clarify that the corporate governance is context-related, that is why there are no world-wide agreed-on upon guidelines on corporate governance. Countries like the USA and the UK have recommended standards and ratings like the Shareholder’s Bill of Rights, GMI, ISS or UK Corporate Governance Code. This text will concentrate on the board of directors and its importance to the corporate governance of large listed UK firms. Moreover, examples of companies with good and bad corporate governance will be given while assessing the way and fashion boards of directors’ function.

The board of directors acts as the monitoring tool and link between shareholders and the management. It provides two main functions: advisory and oversight. On one side it consults with management regarding the strategic and operational direction of the company and on the other it ensures that the management is acting diligently in the interests of the shareholders- which is to ‘maximize the current value per share of the existing stock.’ (JORDAN, 2019) Boards can have different structures such as one or two-tiered and directors can be of many different types, for example non-executive. Additionally, the degree of independence from the management can also vary depending on the status of the chairman and there are multiple committees within the board. All these variables can potentially create an advantage or a disadvantage for the corporate finance depending on the context.

Firstly, the board independence seems to be a very important subject when it come to the board of directors’ effectiveness. Agreeing are ‘Good-governance advocates and stock exchange heavyweights alike have argued that boards with too many insiders are less clean and less accountable.’ (Sonnenfeld, 2020). Independence refers to the degree to which members of the board are not influenced by the management of the same company or other stakeholders. It implies that conflicts of interests might negatively affect the shareholders’ main interest, maximization of stock value/price (JORDAN, 2019). Also, a sign of independence in a company would be constructive opposition between directors and management. However, many companies have what is called dual chairman or CEO, where the head of management is also the head of the board. Even though it is contradictory to the idea of independence it does have a couple advantages. For example, it helps create a clear direction of a single leader according to the stewardship theory (Peng, Zhang and Li, 2007). Unfortunately, the disadvantages surpassed the advantages in the case of Polly Peck. A large UK listed company that collapsed in 1990 because the board could not stop the dual CEO from acting against the shareholders’ interest, ‘Asil Nadir guilty of stealing millions of pounds from his own companies’ (Dominic Casciani, 2020). More exactly the dual CEO situation created a second layer of monitorization which meant that the criminal was monitoring himself therefore arising an agency problem. In other less dramatic situations, a dual CEO can lead to exaggerated compensations and even abuse of power in the company. A solution would be appointing or introducing a lead independent director, a person that has the duty to represent the directors of the board in relation with management and other stakeholders, ‘Appointing a lead independent director, in combination with other factors, is associated with improved future operating performance and stock price returns’ (Larcker, Richardson and Tuna, 2007).

Greggs (LSE: GRG) is Britain’s most Admired Company in 2019 according to Management Today (Saunders, 2020) due to its incredible rise in the past couple of years and the beloved products it offers. The turnaround is due to the board’s independence and the skills of the directors. For once the chairman and CEO are two different people which ensure a right monitoring over the management, it helps create a better understanding of the separation of responsibility between the management and the board, and allows the CEO to focus on the strategy of the company without having to deal with the chairman. In addition is avoids any possible conflicts when evaluating CEO performance and compensation. Also, the recruitment of new directors will not be influenced by the management. Besides all these having separation between the two positions is gives full authority to the chairman to speak to stakeholders. Simultaneously, Greggs board of directors is also rich in diversity when it comes to the members’ past experience and skills. Besides having prestigious actors of industry their skills seem to be in complement. For example, the chairman has a background in international finance while other non-executive members have backgrounds in food retail, food manufacturing, branding and law. Together these two factors: the board’s independence and the skills that complement each other have helped Greggs become what it is today, furthermore is has also gained appraisal for its socially responsible way of doing business, ‘Jamie Dimon and the Business Roundtable are touting responsible capitalism that looks beyond investors to other stakeholders, such as employees, communities and the environment. Greggs has been doing it for decades.’ (Masters, 2020).

Ultimately, the collapse of the MG Rover Group in 2005 is clearly due to the bad governance the board of directors has induced. Nicknamed as the ‘Phoenix Four’, the four board members have fraudulently appropriated cash from the firm through a series of dubious manoeuvres until it fell in financial ruin. Arguably, the small size of the board allowed such disaster to happen. Usually, ‘small’s considered good, big’s considered bad. But big boards exist at some great and admired companies—GE, Wal-Mart, and Schwab—along with some poorly performing companies like US Airways and AT&T. At the same time, small boards are part of the landscape at good companies like Berkshire Hathaway and Microsoft ‘(Sonnenfeld, 2020). Usually there are a couple committees such as: audit committee, compensation committee, social and corporate responsibility committee, nomination committee and risk committee that ensure the good functionality of a large firm. Whereas, the audit committee had to look over the integrity of financial statements and reporting processes, monitor the internal audit function and make sure it is not influenced by the management. On top of these, the committee had the responsibility to appoint the right external auditor (Klein, 2002). At the same time, the governance committee had to manage the implementation of the corporate governance code and the code of ethics and possible conflict of interest policies. MG Rover Group did not take proper advantage of the committees and got into a situation that could have been avoided otherwise.

In conclusion, we have seen how detrimental a good functioning board of directors is to the corporate governance of a firm. The only difficult thing is that corporate finance depends of the context, which means that what might work for a company could not for another. This was illustrated in the examples given. Furthermore, the independence of the board can be good in most cases like in the Greggs example, or at least it could have avoided disasters as seen in the Polly Peck situation. Nevertheless, a dual CEO could be more useful to a smaller company or to a company that needs to do a turnaround not to mention the case where the CEO is also a big equity holder. Also, having a well built and diverse board can also bring lots of benefits, especially when the skills brought by the members are able to converge. In the last case the importance of board size and committees are highlighted. At last, this essay evaluates the importance of the board of directors to the corporate governance of large listed UK firms. The result is that it is indeed a very important factor of influence. At the same time I am wondering whether governments should set strict rules or even if it would be able to do so, considering that corporate governance is dependent on the context. 

Reference List:

  • Anon, (2014). [online] Available at: https://www.ft.com/content/5823a7cc-4279-11e4-9818-00144feabdc0 [Accessed 28 Jan. 2020].
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  • G20/OECD Principles of Corporate Governance 2015. (2015). .
  • JORDAN, B. (2019). ISE ESSENTIALS OF CORPORATE FINANCE. [S.l.]: MCGRAW-HILL EDUCATION, pp.8-13.
  • Sonnenfeld, J. (2002a). New CEO Survey by Yale School of Management and Gallup Organization Reveals that "Serial Acquirer" CEOs Are Driven by Ego Rather than Business Opportunities; Survey Also Shows Many CEOs Feel Their Board Members do not understand their Firm's businesses. [online] Yale School of Management. Available at: https://som.yale.edu/news/news/new-ceo-survey-yale-school-management-and-gallup-organization-reveals-serial-acquirer-ceos [Accessed 28 Jan. 2020].
  • Sonnenfeld, J. (2002b). What Makes Great Boards Great. Harvard Business Review. [online] Available at: https://hbr.org/2002/09/what-makes-great-boards-great [Accessed 29 Jan. 2020].

 

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