Excerpt
Table of Contents
1. Introduction
2. Origins of Independent Directors
a) Why Managers Need to be Monitored by (Independent) Directors
b) Rise of Independent Directors in the US
c) Independent Non-executive Directors in the UK
3. Definition of Independence
4. The Monitoring Role of Independent Directors and Key Elements for their Effectiveness
a) Independence
b) Knowledge and Skills
c) Incentives and Engagement
5. Limitations on the Effectiveness of Independent Directors and
Proposals for Improvement
a) Appointment and Structural Bias
b) Lack of Firm-Specific Knowledge and Expertise
c) Information Asymmetries
d) Time Constraints and Multiple Directorships
e) Influence of Board Tenure on Independence
f) Free-Riding Problems
g) Incentives and Remuneration
h) Lack of Board Diversity
i) Liability and Accountability
6. Conclusion
Bibliography
1. Introduction
Independent (non-executive) directors1 have long been regarded as an essential corporate governance instrument in monitoring and disciplining the senior executives of listed companies, both in the UK and the US.2 However, large corporate scandals and the global financial crisis at the beginning of the 21st century have shown that independent directors have not entirely met the high expectations placed on them.3 Doubts about their effectiveness in holding the management to account have arisen.
In the 2001 collapse of the US energy company Enron, for example, independent directors were not able to forestall the questionable accounting practice of the company, although the board consisted of a majority of independent directors.4 Furthermore, the 2008 global financial crisis has revealed further shortcomings of the governance system at that time. In particular, independent directors were not able to prevent the ‘excessive risk-taking’ of companies; deficits in understanding the business they were supposed to monitor and passivity in dealing with structural problems of the company contributed to this.5
As a consequence, recommendations to improve board effectiveness and corporate governance have focussed on the role of independent directors in the past decade.6 Legislation and corporate governance codes have been reinforced with respect to board independence.7 For instance, the US Sarbanes-Oxley Act 2002 and the Dodd-Frank Act 2010 have strengthened board independence and the New York Stock Exchange Listing Rules mandated boards of publicly traded companies to be composed of a majority of independent directors. In the UK, Derek Higgs was appointed by the Department of Trade and Industry to ‘review the role and effectiveness of non-executive directors’ in 2002. His report8 pointed out several shortcomings of the role and functioning of non-executive directors and provided a number of recommendations. These have been largely adopted in the 2006 guidance on ‘Good Practice Suggestions from the Higgs Report’ by the Financial Reporting Council which has since been replaced by the ‘Guidance on Board Effectiveness’ which accompanies the UK Corporate Governance Code.9
Despite these efforts, further corporate scandals have continued to call into question the effectiveness of independent directors. Most recently, the collapse of Carillion prompted the UK Government to summarise in their report that Carillion’s non-executive directors ‘failed to scrutinise or challenge reckless executives’ and were ‘unable to provide any remotely convincing evidence of their effective impact’.10 Moreover, a recent study found that even though the ‘post-crisis reforms’ have considerably reinforced the role of independent directors, they have had ‘no impact on the banks’ risk-taking’.11
On this occasion, this essay critically discusses the effectiveness of independent directors in monitoring and disciplining the senior executives in the UK and the US. By exploring the role of independent directors, particular attention is paid to the limitations of the current governance systems from a legal and practical point of view. It becomes clear that many of the shortcomings attributed to the concept of director independence have arisen precisely from the requirement to have a majority of independent directors on the board. The essay also presents proposals to improve the effectiveness of independent directors.
The essay is structured as follows. Section 2 explores the origins of independent directors in the UK and the US and answers the question why managers need to be monitored by (independent) directors. Section 3 then outlines the different standards and definitions of independence in the UK and US corporate governance systems. Subsequently, section 4 goes into more detail on the monitoring role of independent directors while stating the key components for effectiveness. Section 5 critically discusses the main limitations of independent directors in monitoring and disciplining the senior executives, followed by a series of proposals to improve their effectiveness. Section 6 concludes.
2. Origins of Independent Directors
Before assessing the effectiveness of independent directors in monitoring and disciplining the senior executives and proposing improvements, it is necessary to explain why corporate governance systems have attributed such importance to the independence of directors and why (independent) directors are the appropriate corporate constituency to monitor the management.
a) Why Managers Need to be Monitored by (Independent) Directors
Most publicly traded companies are characterised by a ‘separation of ownership and control’.12 Because share ownership in such companies is widely dispersed in the UK and the US, no individual shareholder owns enough shares to influence corporate decision-making.13 Furthermore, the hurdle of reaching consensus among thousands of shareholders, largely divergent interests as well as different information levels and investment time horizons prevent shareholders from an active role in corporate decision-making.14 Likewise, shareholders have insufficient incentives to obtain necessary information for informed decisions, unless the expected benefits outweigh the costs.15 Thus, shareholders are ‘rationally apathetic’ and prefer to sell their shares if they are disgruntled with the management of the company rather than to discipline the senior executives.16
Consequently, the board of directors has been identified as the central corporate decision-making body due to their information advantages, either by state statute (US)17 or via delegation under the company’s articles (UK).18 According to the prevalent unitary board structure in the UK and the US, boards consist of both, executive and non-executive (independent) directors sharing management and control of the company.19 Typically, the management powers of the board are sub-delegated to the senior executives under the company’s articles who therefore make the corporate decisions alone.20
As a result of the separation of ownership and control, agency costs potentially arise because the interests of shareholders and managers may diverge.21 Managers are not absolutely loyal. They may abuse their control in a way of self-dealing at the expense of shareholders and they may also have incentives to shirk.22 The shareholders as principals incur costs through monitoring and bonding their agents as well as residual loss. Hence, effective mechanisms to take managers to account are crucial to reduce agency costs.23 For the above reasons, the shareholders themselves appear to have the least incentives among the corporate constituencies to effectively monitor the managers. Accordingly, corporate governance systems provide the board of directors as an alternative accountability mechanism, in particular the independent directors who should have the right incentives to monitor and discipline the senior executives.24
It is assumed that directors who are independent from management effectively safeguard the interests of shareholders because they can exercise independent judgement.25 Therefore, independence has been regarded as an essential element of good corporate governance. This leads us to the development of independent directors in the US and the UK corporate governance systems.
b) Rise of Independent Directors in the US
Independent directors have long been considered an essential mechanism of corporate governance in the US. The predominant ‘monitoring model’26 which emphasized the monitoring of managers as the main role of the board has highly influenced the US corporate governance system.27 For example, the early American Law Institute’s ‘Principles of Corporate Governance: Analysis and Recommendations’ provided for a functional division between the senior executives who manage the company and the board of directors who oversee the managers.28 In addition, it recommended that the board of a publicly held company be composed of a majority of independent directors. The objective was to ensure an objective evaluation of management’s performance by the board.29
In response to a series of large corporate scandals at the beginning of the 21st century, the Sarbanes-Oxley Act 2002 has strengthened the independence of a board by mandating publicly traded companies to establish audit committees entirely comprised of independent directors.30 Moreover, in the aftermath of the global financial crisis the Dodd-Frank Act 2010 has introduced mandatory risk and compensation committees for quoted companies consisting exclusively of independent directors.31
While state corporate law generally does not prescribe independent directors, the Listing Rules of the New York Stock Exchange (NYSE) as well as other stock exchanges (NASDAQ, AMEX) require a majority of the board of listed companies be independent directors.32 In addition, the mandatory audit, compensation and nomination or corporate governance committee must be composed solely of independent directors.33
c) Independent Non-executive Directors in the UK
The Cadbury Report 1992 first introduced the concept of independent non-executive directors in the UK, similar to the US model.34 The report recommended that ‘the calibre and number of non-executive directors on a board should be such that their views will carry significant weight in the board’s decisions’.35 In particular, boards of listed companies should include at least three non-executive directors with a majority being independent from the company. Furthermore, the report suggested the establishment of a nomination, audit and remuneration committee comprising a majority of non-executive directors.36 Subsequent reviews by the Greenbury37 and Hempel38 Committees further promoted the significance of independent non-executive directors, but it was the Higgs Committee which first recommended a majority of the board of directors be independent.39 This recommendation was later incorporated into the revised Combined Code on Corporate Governance 2003 which was the predecessor to the current UK Corporate Governance Code. After the financial crisis and promoted by the Walker Review40, the focus has shifted more on the board’s balance of ‘skills, experience and knowledge’.41
The Companies Act 2006 is silent on the role of independent non-executive directors as it does not distinguish between executive and non-executive directors. The corresponding provisions are contained in the UK Corporate Governance Code. Accordingly, the board should include ‘an appropriate combination of executive and non-executive (and, in particular, independent non- executive) directors, such that no one individual or small group of individuals dominates the board’s decision-making’.42 At least half of the board should be composed of independent non-executive directors.43 Furthermore, the board should establish a nomination committee with a majority of members be independent non-executive directors as well an audit and remuneration committee of independent non-executive directors with at least three, or in smaller companies below FTSE44 350, two members.45
Finally, the Financial Conduct Authority’s Listing Rules provide for a dual voting structure regarding the appointment of independent directors in premium listed companies with a controlling shareholder.46
3. Definition of Independence
The requirement to have independent directors on the board (see sections 2a) and b)) has little importance in itself; the criteria for independence and who determines whether a director is regarded as independent are decisive.47 However, there is no universal definition of ‘independence’.48
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1The term ‘independent directors’ is used in the US corporate governance regime whereas the UK Corporate Governance Code uses the term ‘independent non-executive director’. For the sake of simplicity, the term ‘independent directors’ is used in this essay which includes both variants, unless otherwise indicated.
2Wolf-Georg Ringe, ‘Independent Directors: After the Crisis’ (2013) 14[3] European Business Organization Law Review 401, 402.
3Paul L Davies and Klaus J Hopt, ‘Corporate Boards in Europe – Accountability and Convergence’ (2013) 61[2] American Journal of Comparative Law 301, 322.
4Klaus J Hopt, ‘Comparative Corporate Governance: The State of the Art and International Regulation’ in Andreas Fleckner and Klaus J Hopt (eds), Comparative Corporate Governance: A Functional and International Analysis (Cambridge University Press 2013) 52.
5Ringe (n 2) 402.
6Davies and Hopt (n 3) 318.
7Alessandro Zattoni and Francesca Cuomo, ‘How Independent, Competent and Incentivized Should Non-Executive Directors Be? An Empirical Investigation of Good Governance Codes’ (2010) 21[1] British Journal of Management 63.
8Derek Higgs, ‘Review of the Role and Effectiveness of Non-Executive Directors’ (2003).
9 Financial Reporting Council, ‘Guidance on Board Effectiveness’ (2018).
10 Business, Energy and Industrial Strategy and Work and Pensions Committee, Carillion (HC 2017-19, 769) para 59.
11 Laura Noonan, ‘Independent Directors Have No Impact on Bank’s Risk-Taking’ The Financial Times (New York, 31 July 2017) <https://www.ft.com/content/164adca8-7142-11e7-aca6-c6bd07df1a3c> accessed 27 March 2019.
12 Adolf A Berle and Gardiner C Means, The Modern Corporation and Private Property (Macmillan 1932); Stephen M Bainbridge, ‘The Board of Directors’ in Jeffrey N Gordon and Wolf-Georg Ringe (eds), The Oxford Handbook of Corporate Law and Governance (Oxford University Press 2018) 279 and 289-292.
13 Berle and Means (n 12) 84-89.
14 Stephen M Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (1993) 61[4] George Washington Law Review 1034, 1054-1055; Bainbridge, ‘The Board of Directors’ (n 12) 293-294.
15 ibid.
16 Frank H Easterbrook and Daniel R Fischel, ‘Voting in Corporate Law’ (1983) 26[2] Journal of Law and Economics 395, 402; Martin Lipton, ‘Corporate Governance in the Age of Finance Corporatism’ (1987) 136[1] University of Pennsylvania Law Review 1, 66-67.
17 Delaware General Corporation Law (Title 8 Chapter 1 Delaware Code), s 141(a).
18 Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1052-1053 and 1055-1056; Paul L Davies and Sarah Worthington, Gower’s Principles of Modern Company Law (10th edn, Sweet & Maxwell 2016) paras 14-1-14-5; Bainbridge, ‘The Board of Directors’ (n 12) 276-278.
19 Davies and Hopt (n 3) 311-313; Hopt (n 4) 29-31; Bainbridge, ‘The Board of Directors’ (n 12) 277.
20 Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1052; Davies and Worthington (n 18) paras 14-3 and 14-9-14-10.
21 Berle and Means (n 12) 6; Michael C Jensen and William H Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’ (1976) 3[4] Journal of Financial Economics 305, 308; Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1057; Bainbridge, ‘The Board of Directors’ (n 12) 279 and 295-296.
22 Berle and Means (n 12) 121-122; Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1057; Bainbridge, ‘The Board of Directors’ (n 12) 279.
23 Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1057; Bainbridge, ‘The Board of Directors’ (n 12) 279 and 298.
24 Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1058 and 1060; Bainbridge, ‘The Board of Directors’ (n 12) 280 and 298-300.
25 Eugene F Fama, ‘Agency Problems and the Theory of the Firm’ (1980) 88[2] Journal of Political Economy 288; Eugene F Fama and Michael C Jensen, ‘Seperation of Ownership and Control’ (1983) 26[2] Journal of Law and Economics 301; Christopher Pass, ‘Corporate Governance and the Role of Non-Executive Directors in Large UK Companies: An Empirical Study’ (2004) 4[2] Corporate Governance: The International Journal of Business in Society 52, 53; Zattoni and Cuomo (n 7) 65.
26 Melvin A Eisenberg, The Structure of the Corporation: A Legal Analysis (Brown and Company 1976) 139-141.
27 Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1046; Guido Ferrarini and Marilena Filippelli, ‘Independent Directors and Controlling Shareholders Around the World’ in Jennifer G Hill and Randall S Thomas (eds), Research Handbook on Shareholder Power (Edward Elgar 2015) 269-270; Bainbridge, ‘The Board of Directors’ (n 12) 281-282.
28 Bainbridge, ‘Independent Directors and the ALI Corporate Governance Project’ (n 14) 1039-1040.
29 ibid 1037.
30 Sarbanes-Oxley Act 2002, Public Law 107-204, 116 Stat 745, s 301; Zattoni and Cuomo (n 7) 63; Hopt (n 4) 37; Ringe (n 1) 403; Ferrarini and Filippelli (n 27) 270; Sally Wheeler, ‘Independence and Diversity in Board Composition’ in Roman Tomasic (ed), Routledge Handbook of Corporate Law (Routledge 2017) 84-86; Bainbridge, ‘The Board of Directors’ (n 12) 282 and 311.
31 Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, Public Law 111-203, 124 Stat 1376, s 952; Hopt (n 4) 37; Ringe (n 2) 406-407; Wheeler (n 30) 91-92.
32 NYSE Listed Company Manual, s 303A.01; Hopt (n 4) 37; Ferrarini and Filippelli (n 27) 270; Bainbridge, ‘The Board of Directors’ (n 12) 310-312.
33 NYSE Listed Company Manual, ss 303A.04, 303A.05 and 303A.06; Hopt (n 4) 37; Ferrarini and Filippelli (n 27) 270; Bainbridge, ‘The Board of Directors’ (n 12) 311-312.
34 Hopt (n 4) 37; Ferrarini and Filippelli (n 27) 271.
35 Adrian Cadbury, ‘Report of the Committee on the Financial Aspects of Corporate Governance’ (1992) paras 4.11-4.12.
36 ibid paras 4.30, 4.35 and 4.42.
37 Richard Greenbury, ‘Directors’ Remuneration: Report of a Study Group Chaired by Sir Richard Greenbury’ (1995).
38 Ronnie Hampel, ‘Committee on Corporate Governance: Final Report’ (1998).
39 Higgs (n 8) para 9.5; Pass (n 25) 52-53; Zattoni and Cuomo (n 7) 64; Hopt (n 4) 37-38; Ferrarini and Filippelli (n 27) 271; Wheeler (n 30) 86-87.
40 David Walker, ‘A Review of Corporate Governance in UK Banks and Other Financial Industry Entities’ (2009).
41 Financial Reporting Council, ‘The UK Corporate Governance Code 2018’ (UK Corporate Governance Code 2018), Principle K; Davies and Hopt (n 3) 326; Hopt (n 4) 39 and 45; Ferrarini and Filippelli (n 27) 271; Wheeler (n 30) 91.
42 UK Corporate Governance Code 2018, Principle G.
43 ibid Provision 11.
44 Financial Times Stock Exchange Index.
45 UK Corporate Governance Code 2018, Provisions 17, 24 and 32.
46 Financial Conduct Authority Handbook (FCA Handbook), LR 9.2.2E- LR 9.2.2F.
47 Hopt (n 4) 39.
48 Higgs (n 8) para 9.8; Zattoni and Cuomo (n 7) 65; Davies and Hopt (n 3) 319; Hopt (n 4) 51; Ringe (n 2) 410 and 414; Ferrarini and Filippelli (n 27) 276.