Failure of corporate governance
For running the business of companies, especially large public companies we need efficiency, transparency and accountability. Corporate governance is the process to control and direct the companies for long term results . There has been many ways to achieve this via good corporate governance but failure of some big companies raised various questions and issues. One of these big corporate failures is the collapse of Enron, a successful company in the United States. ‘Enron' was a symbol of success in the market and when it collapsed in 2001 the relevant regulatory bodies in the US decided to look in to the reasons of failure of this giant company. In the UK the government i.e. Department of Trade and Industry decided to look in to the reasons why such a successful company failed and to avoid such corporate disasters in the UK .There were many reasons for the collapse of Enron but one of the major concerns was the role and lack of effectiveness of non-executive directors. For this purpose Sir Derek Higgs was appointed to review the role of NEDs and how to make the NEDs more effective and improve the corporate governance
The recommendations made by Derek Higgs are called ‘Review of the role and effectiveness of non-executive director's. As the name of the review suggest there has been strong emphasis on the role of non-executive directors. Higgs has called the NEDs as the “custodians of the governance process”. Most of the Higgs work has been dedicated to the role of NEDs and it appears that full time executive directors will be supervised by part time NEDs. This is why some scholars criticise the Higgs review for the fact that it has placed too much reliance on the Non-executive Directors.
However deeper appreciation of the Higgs review reveals that it not only attaches too much importance to the effectiveness of non-executive directors but other important matters of corporate governance has been taken in to account as well for achieving better results.
Therefore Higgs review not only emphasises on the importance of non-executive Directors but has made recommendation about audit committees, institutional shareholders, the role and separation of chairman and CEO. One of the salient features of the Higgs review is that the it provided a definition as to what constitute “independence” for the purpose of appointing a non-executive director and chairman, and what is meant by independent director. The Higgs further suggest that there shall be a senior independent director to look after the issues of institutional shareholders. Higgs further emphasised on the separation of the role of chairman and chief executive.
In this essay the role of non-executive directors has been critically analysed and it has been tried to look in to the Higgs recommendations that how far the Higgs review has been successful in making NEDs effective in achieving good corporate governance. The essay will also take in to account whether the Higgs recommendation is only about NEDs or does it take other components of the board of corporate governance in to considerations as well. Therefore the essay will try to find out what are the other contributions made by the Higgs review. The essay will also appreciate some of the main problems of corporate governance. It will examine the problems faced by non-executive directors and will try to make recommendations accordingly. It will also try to look what could be the way ahead for the non-executive directors in the future. Furthermore the essay has also tried to appreciate other various reviews and recommendations made at different times in order to have a comprehensive debate on the role and effectiveness of the non-executive directors and to examine whether the Higgs Recommendations are in line with other recommendations. The essay will also be looking in to the ‘Walker review 2009'.
For the purpose of referencing, efforts have been made to follow the new guidelines provided by OSCOLA for legal research
Voluntaryapproach of “Comply or Explain”
The rules to be followed by the companies in the UK are soft laws and are based on the principle of ‘comply or explain. According to this approach the companies shall either follow the code of on corporate governance otherwise explain the reason why the company has not complied with the code. According to Higgs the rationale of this approach is that it provides flexibility and intelligent discretion to the companies.
However in the United States of America after the collapse of Enron US Sarbanes- Oxley Act in of 2002 was passed and it applies to all US and non-US companies. Under the Act, companies are required to file periodic reports with the Securities and Exchange Commission. This approach is different from the UK approach of comply or explain, as under the US 2002 Act failure to comply with the relevant provisions of Act is an offence
The main difference between the US and the UK approach lies in the consequence of failure. In the UK, failure to comply with the “UK code of Corporate governance” is not an offence while in the US it is offence to not to comply with the 2002 Act.
Some of the major problems of Corporate Governance
Before looking in to the Higgs Recommendations and other recommendations it is important to look in to some of the major problems of corporate governance in the UK and worldwide. There are various concerns that need to be addressed by good corporate governance for the achieving better results. Some of the these problems to be discussed in the following lines resulted in abuse and the collapse of major companies and therefore made a way for reform in corporate governance in the UK. Though these problems are different in nature and have different dimension but some of them could be avoided if effective non-executive directors are available on board.
One of the problems faced by corporate governance is the principal-agent problem or agency cost problem. This notion is based on the separation of ownership and control. As the directors remain in charge of company's finances which make them the agents and the company and the company as principal of the agents i.e. directors. There is likely- hood of the danger that the directors may in certain circumstances will be tempted to ignore the interest of the company and work for their own interest. To avoid this clash of interest between agents here the directors and principal, here the company, there is need to require agents to promote the success company, or in other words the success of the principal. One of the other solutions to manage the agency cost problem is to have non-executive directors in the company.
Conflict of interest is another problem which needs due attention in the corporate governance debate. In many cases loyalties are compromised for personal benefits. In Enron the husband of the chairman of the audit committee received political donations from the company. Such unethical activities lead to securing personal gains instead of giving priority to the company affairs.
Transparency is one of the essential requirements of good corporate governance but sometimes companies lie about their accounts for various reasons. One of such technique is called “creative accounting”. It is the falsification of accounts figures The main purpose of this unfair practice is to inflate profits and attract investment This can be seen in the case of Enron where devious accounts showed enormous profits while in fact this was not the fact. Now in the US accounting frauds are regulated through the Sarbanes Oxley Act 2002.
The results of audit failures are very serious and in a big company like Enron they could send shock waves to the many countries. This results not only in corporate failures but diminishes the confidence of the investors on the auditing profession. Failure by the auditors to find fraudulent activities may result in the abuse of company finances and thus may lead to failure of the company.
Another issue of corporate governance is about the cases where the executive directors have been dominant over the non-executive directors and so non-executive directors lack independence and are not effective. This results in lack of monitoring of the executive directors. This was seen in the case of Enron and Parmalat. In Parmalat the director was not independence while in Enron the executive were dominant over the non-executive directors.
In many cases executive are paid very high salaries and bonuses without any considerations to their performances. Or in other words they are paid excessive remunerations. These excessive remunerations gave birth to the notorious term of ‘fat cat' arising from British Gas where executive were paid excessively. Because of public and shareholders outcry in 1995 the Greenbury committee was formed to look in to the directors remunerations. Greenbury recommended that remunerations must be linked to performance. Recently MG Rover, a case of corporate collapse, one of the director received $40 million in terms of wages and pension during his time in the company while an inquiry held that the company was suffering from mismanagement but the directors pay was excessive. In this case four of the directors were banned to serve as directors of company in the future. Had there been effective and independent directors there might have been better supervision and the results might have been different.
Along with these problems is the issue when companies give too much power in the hands of an individual. In many cases one person enjoy the powers of two separate positions i.e. to work at the same time as Chief Executive officer and chairman of the board. The combination of these two important position results in the concentration of powers in the hands of one person and thus results in the abuse of powers. This can be seen from the collapse of Maxwell Communications, where Robert Maxwell was in charge of two main positions. Robert Maxwell held the positions of Chief executive and chairman in Maxwell Communications from 1981till 1991. He abused his powers and the result was the scandal was so big that his scandal at that time was termed as the biggest scandal of the 20th century. He stole approximately £727 million from the pension funds of the companies he of which was charge as chief executive and chairman. Cadbury also emphasised on the separation of powers at these two positions and held there must a balance of powers between individuals.
So these are some of the problems of corporate governance and these matters must the subject of continuous review in order to minimise the risks of corporate failures.
In many cases if not in all, effective and independent non-executive directors, as have been suggested by Cadbury and Higgs and other recommendations could work as an effective tool and some of these happening can be avoided.
Who are Non-Executive Directors?
Though the company is a legal entity in itself with its own legal and financial rights and liabilities but it needs real people to run and manage the business of the company. The people who are responsible for the management of the company are called directors of the company. Further under section 154 of the ‘Companies Act 2006' it is a statutory requirement for the company to have a minimum number of directors. For a public company this requirement is two people while for a private company it is one person. Directors or the person who manage, run and supervise the business and transactions are usually divided in to two classes; executive directors and non-executive directors. There is a stark different between the role of executive directors and non-executive directors. An executive director is an employee of the company and allocates a lot of the time to the day to day affairs and work of the company. While a non-executive director is not the employee of the company and allocates comparatively less time to the affairs of the company. The nature and role of the non-executive directors is considered in the following lines.
Different Reviews and Reports onNEDs and a brief Back Ground
As there are various recommendations, committees reports and developments on the role of the non executive directors and it is worthy to look in to some of these committees and recommendations.
Cadbury Committee 1992and Non-Executive Directors
In order to improve corporate governance and introduce more accountability to the boardroom, Sir Adrian Cadbury, in his recommendations” The Financial Aspects of Corporate Governance”recommended that in order to achieve accountability in the boardroom there is need for non-executive directors. The role expected from the non-executive directors is supervisory in nature and thus Cadbury committee recommended that non-executive directors are a tool to monitor executive directors. Cadbury committee was not the first one to talk about the NEDs and the Bank of England has also considered the role of Non-Executive Directors during and after the recession of 1980s. However Cadbury committee presented non-executive directors as a solution for accountability in company board of directors and it appear it was the first time there was strong emphasis on the appointment of the non executive directors
The Cadbury Committee recommended that board of the company should have sufficient number of non-executive directors and they must be in a position to influence the decision of the board. It further recommended that non executive directors should be independent. It was the initial code of practice for good corporate governance and strongly recommended the appointment of non-executive directors. According to Cadbury NEDs have twofold responsibilities, on the one hand to supervise the board and on the other hand if there is any danger of conflict of interest, the non executive directors should be at the fore front to take the lead to resolve the conflict
Greenbury Committee 1995 and Non-Executive Directors
In response to shareholders and public concerns over the remunerations of the directors, the government set up a corporate governance committee to look in to the accusation of excessive remunerations of executive directors. This committee was headed by Sir Richard Greenbury. The committee recommendations were called, Directors Remunerations,Report of the Study Group, and made important recommendations. The 1995 committee recommended that there should non executive directors on remuneration committee of the company. The reason given by ‘Greenbury committee' to have non executive directors on the remuneration committee was that there is inherent conflict of interest on the part of the executive directors and non executive directors must look in to the matter of salaries when the company has to make decisions about the salary of the executive directors. This is another example which suggests the importance of the non executive directors in the corporate governance process.
It was one of the recommendations of the Cadbury Committee that there shall a committee to review the effects of the Cadbury recommendations and make changes where necessary. Therefore in pursuance of Cadbury recommendations Sir Ronald Hampel chaired a committee and reviewed Cadbury and Greenbury recommendations and came with some new recommendations.
Like Cadbury and Greenbury, Hampel also emphasised on the importance of non-executive directors. Hampel went a step a further and suggested that non-executive directors must have a leader. According to Hampel non-executive must constitute one third of the board and that they must be independent.
Limitations of these recommendations
All these reports of corporate governance have made good recommendations about the non-executive directors but still there were some shortcoming and limitations in these reports and recommendations. None of these reports and reviews has a clear and comprehensive guidance about independence the definition of independent non-executive director. These definitions are not clear about the role of the non-executive directors. Neither of them clearly specifies the numbers of non-executive directors. Further there has been a demand for a balance between executive and non executive directors but none of these reviews had a clear idea what should be a balance.
Due to these shortcomings there was a need for a comprehensive review of the role of non-executive directors. The recommendations made by Higgs review are considered comprehensive though subject to criticism from some quarters. (Put reference)
The Higgs Review2003,‘Review of the Role and Effectiveness of the Non-executive Directors'
Higgs Review is a very important review and focuses on many aspects of corporate governance and board effectiveness. It was made in a reaction to the collapse of Enron and to further improve the UK corporate governance framework initiated by Cadbury report in 1992. The Higgs Report included many important recommendations about non executive directors, provided definition of independence, provided guidance for chairman. It also provided proposal for the revised combined code. The recommendations were warmly welcome by the then government. The main purpose of the Higgs committee was to review the role of non-executive directors in the corporate governance process. In order to assess and examine the need and importance of non executive directors and what skills they will bring in to the boardrooms, it took Mr Higgs about six months to reach these conclusions. In support of his recommendations sir Derek Higgs was reported saying that it will help to stop ‘box-ticking' approach towards compliance and will serve for achieving best practices in corporate governance. It is however important to remember that Higgs review was not about the non-executive directors only.
The main recommendations of the Higgs Review about non-executive directors)
Though Higgs report was not about non-executive directors only but the importance placed by the Higgs review on the non-executive directors can be seen from the fact that it has called non-executive directors as the “custodians of the governance process”. The reason given by Higgs in this regard is that businesses have adopted a complex shape and it is not easy for the shareholders to make the company executive management accountable. It further held that corporate failure are very hard to prevent and the risk of failure always exist but the presence of non-executive directors will minimise that risk. Higgs review strongly support the unitary or single board system for the UK as against the two tier board system that exist in some of the European countries. The Higgs consider that in unitary board the knowledge and skills of both executive and non-executive directors are combined.
The purpose of this review was to bring strength to the quality, independence and effectiveness of non-executive directors in the UK.
Definition of independence given by Higgs Review
One of the main contributions of the Higgs review is that it provided a definition that what is meant by independence. Chapter nine of the review has provided the definition which says that a non-executive director is considered “independent”when he is independent in judgment and character and there are no relationships or circumstances which could affect director's judgment.
The review has made it clear what would be the circumstances or relationships which could affect the director judgment and will impair his independence. These are outlined in the following lines.
- Where the director is a former employee of the company until there is a lapse of five years after the employee has come to an end.
- Where the director has a material business relationship with the company in the last three years.
- Another aspect that may affect the independence of the non-executive director is where he has family ties with the company's directors, advisors or senior employees.
- A non-executive director may not be considered independent where he has served for more than 10 years on the board.
- Where the company pays to the directors remunerations other than director's fee or where the director is member of the company pension scheme.
- Where the director is representing a significant shareholder
These seven are the circumstances the existence of which could affect the judgment of the directors. The review further provides that the board of the company in its annual report should identify the non-executive directors which it consider as independent. Further if any of the non-executive directors is considered independent in spite the fact there exist a relationship or circumstances then board must give its reason that how the director with the relationship or circumstance is independent. Higgs further recommended that half of the board must consist of the independent non-executive directors.
The role of non-executive directors under the Higgs Review
Chapter six of the Higgs review outlines the description of the role of non-executive directors for good corporate governance. The role given to non-executive directors consists of the of; Strategy, Performance, Risk and People,
- Strategy:That non-executive director must constructively challenge and help executive to develop proposals on strategy.
- Performance:they must scrutinise managerial performance in meeting the agreed objectives and monitor reporting standards.
- Risk:Non-executive directors must satisfy on the integrity of financial information and ensure that the financial control and risk management system are robust and defensible.
- People: With respect to people their role include to determine the appropriate level of executive remuneration, play a major role in appointing and removing executive directors andin succession planning.
Keeping the important and unique role of non-executive directors, Higgs requires that non-executive directors should have a strong personal and behaviour attributes.
Furthermore Higgs recommends that non-executive directors must meet once a year and the annual report must mention it. To strike a balance between executive and non-executive directors, Higgs recommended that half of the board must consist of the non-executive directors.
Higgs review has taken the concerns of the shareholder in to account and recommends that a senior independent non-executive director must be appointed who must attend meetings with shareholders on regular basis. The availability of SID or senior independent director will provide shareholders the platform to raise their concerns if any, against the board or management of the company.
The criteria of independence are not only for non-executive directors but equally applicable to senior independent director and to the chairman as well.
The Tyson report 2003“theRecruitment and development of the non-executive directors”.
Higgs review was followed by the Tyson report “the recruitment and development of the non executive director. Higgs Report has recommended that a group of business leaders be formed to help in examining the ways to bring talented and prominent candidates with complementary skills, experience and perspective to enhance board effectiveness. Therefore Laura Tyson was asked to lead the group as recommended by the Higgs review. The Tyson report concluded the board effectiveness has been enhanced by diversity, skills and experience of non-executive directors. The report also indicated the diversity in the board has resulted in improving the relationship with corporate stakeholders including employees, shareholders and customers.
Walker Review 2009
In2009 the government initiated a review to look in to a governance matters in banking sector including number of issues, the executive remunerations, board effectiveness, risk management, corporate governance and internal control. This was led by David Walker and was published in November 2009. The review also made recommendations about non-executive directors. The recommendations of the walker review may be summarised in the following lines:
- That there shall be a dedicated non executive director who is supposed to focus on risk only.
- That there shall be more training and business awareness sessions for the non-executive directors.
- Walker review also found that the non-executive directors in the big banks failed to properly supervise the executives.
- Walker review further found that non-executive directors devote too little time annually which is 20 to 25 days. Walker recommended it shall be increased to 30 to 35 days each year.
Like the other reviews walker review has its critics and it was criticised on various grounds. One of the criticisms made on the walker review was that some of the reforms suggested in the Walker were already existed. For example it recommended on risk committee but at the same time Northern Rock has a rick committee but its committee failed to avert the Northern Rock failure. Over all however the Walker Review were appreciated especially for the enhanced roll of non-executive directors and has a significant contribution in achieving good corporate governance. Along with non-executive directors walker review also emphasised on the role of chairman.
Arguments in Favour of NEDs
The role of independent and effective non-executive directors has always been recognised in the corporate process for achieving good results and performance. According to Higgs review the role of NEDs has two main components. One is to monitor the activities of the executive and second is to contribute to the development of strategy.
- Monitoringthe executive management;
Therole of non-executive directors has been recognised for improving and monitoring the internal management and performance of the company. They keep vigilance on the executives and try to make sure the executives follow the proper procedures. The lack of supervision has in most cases resulted in corporate collapses and therefore executive needs to be supervised through the outsider non-executive directors. Higgs has described this role of the non-executives as one of the two main components of the role of the non-executive directors.
Before Higgs review there has been no guidance as to what is the role of non-executive directors with respect strategy of the company. Higgs recommends that non-executive directors must contribute to the development of the strategy and be in a position to challenge and question if there is something to which they don't agree.
- Conflict Management
Non-executive directors have an important role where there is a conflict of interest between the executive and the company. They could help in conflict management and are expected to play a lead role.
- Non-executive can attract business
Usually companies with non-executive directors are considered to complying with code of good practices and considered to be working in an efficient manner and therefore it will be attracting investors to invest in the company and thus non-executive directors are sometimes a source of attracting investor for the company. Sometimes some of these non-executives directors are prominent figures with sound skills and thus add further credence to the name and reputation of the company. While on the other side they will not only attract investment in to the company but will play a role in the protection of the investors by effective supervision.
Along with protecting investors non-executive directors are also play an important role in the protection of the interests of the shareholder as well
Arguments Against NEDs
There have been arguments which criticise the non-executive directors for various reasons. These are discussed in the following lines.
One of theobjections raised about the on-executive directors is that they are in most cases appointed by executives and this may compromise the independence of the non-executive directors while independence is an essential characteristic of the non-executive directors. In Some cases non-executive directors may owe their appointment to the executive friends in the company and thus may not be in a position to challenge certain issues which they should.
- Lack of Access to information
It is no more a secret that many corporate scandals happened because the non-executive directors had no access to accurate and timely information, while the effectiveness of the NEDs lies in the fact that they must have access to accurate and timely information. However for information non-executive is dependent on executive directors and therefore affects their credibility.
One of the disadvantages advocated by the critics of the non-executive directors is that while non-executive directors spend less time as compared to executive directors but their liability remains the same. This is evident from case of equitable life insurance where one of the non-executives incurred liability as a director of the company.
- No Statutory Definition on non-executive directors
One of the criticisms made about the non-executive directors is that there is no statutory definition.
Further non-executive directors must be independent but if they are not truly independent.
- Dis-Unity of the board
Some of the critics argue that the presence of the outside non-executive director will create disunity on the board and will result in the reduction of entrepreneurship of the company
Furthermore the presences of the outside non-executive directors are considered a burden on the company. While some critics of the view that non-executive may not have the relevant skills and experience required for the role and thus will not meet the expectations. Sometimes the remunerations of the NEDs are not considered adequate enough. While some of the critics believe the that the time spent by non-executive directors are not sufficient for their duties while some of the NEDs might be working as directors of the other companies and there will be burden on them which will restrict their efficiency. It is also important to note there seems no clear guidance as to how the duties of the non-executive will be enforced and how NEDs are responsible to the shareholders. At the same time there is no relief or guidance in cases where non-executive are not happy from the executive directors.
The way forward for NEDs
The need and importance of non-executive directors is evident from all of the reports and recommendations made till date for achieving better corporate governance because from Cadbury report which started emphasising on the importance of NEDs till date all of the reports have had some part of it allocated to the role and importance of the non-executive directors. It is time for the companies to recognise the importance of the NEDs not only for the company but for the wider society as well. Though there is no denial of the fact that in the last two decades there has been a tremendous improvement in the foundation and structure of the corporate governance and companies have benefited from it and have made their structure better
Therefore it is hoped that in the UK there will be further work on the role of the non-executive directors and UK will be a leading sample and the rest of world must follow the suit.
From all the above discussion we come to various conclusions. The various reports on the non-executive directors make it clear that they have an important role in corporate governance. Since the Higgs review there has been a lot of awareness about the role of non-executive directors. One of the significant achievements of the Higgs review is the change in the listing rules of public listed companies regarding the non-executive directors. Higgs review placed deep emphasis on non-executive directors but it has in fact also considered the other components of the board. Higgs review gave a definition what will amount to independence. It required that for effective board the role and chairman must not be held by one individual. It further recommended that there must be a senior independent director (SID). The senior independent director was required to supervise the concerns of the shareholders. The criteria for the independence must also be met by chairman and SID. In Higgs review recommendations were also made about the function of audit committees.
Though initially Cadbury was the first one to emphasis on the role and importance of the non-executive directors but Higgs review played the role of clarifying many aspects which has not been done before. The different reviews had been asking for a balance between executive directors and non-executive directors but it was Higgs review which provided that in order to get the balance right, half of the board must consist of the non-executive directors.
Had there been effective and independent non-executive directors many corporate collapses might have been either avoided. This especially felt after the collapse of Enron in US and Parmalat in the Europe. Though the risk of failure is always there but the presence of effective and independent non-executive directors can reduce the risk.
The Higgs recommendations is not free from criticism and one of the criticisms on Higgs is that it is soft law, and still the chance it may not be followed in its true spirit and a mere explanation why it is not being followed will allow the companies to avoid any penalty or liability. The main criticism over Higgs is that it has placed too much reliance over non-executive directors. But as mentioned above this criticism fails when we look in to the Higgs recommendations about other matters including the role of chairman, senior independent director and audit committee etcetera. Therefore it is not true that Higgs is all about the NEDs rather it has taken all important aspects of the board room in to consideration.
It is very unfortunate that NEDs are ignored but their role is remembered when something goes wrong in the company. Further NEDs are equally useful in medium and small family companies.
Though the various committees have contributed a lot to the effectiveness of the non-executive directors but there is still the need for further improvements. In this regard it is submitted there must be a statutory definition of non-executive directors. Sometimes non-executive directors hold more than one position by working in different capacities in different companies which affects their efficiency. Therefore it is recommended that there must be a limit on the position they can hold. They need to allocate more time. There need to be some mechanism through which NEDs must be enabled to enforce their grievances', if any against the executive directors.
There must be some partial regulations because code of best practices does not work all the times and it is recommended that there must be some kind of arrangement in the nature of the US Sarbanes-Oxley Act 2002.