Corporate Governance, Independant Directors, Agency Theory

Companies globally need the ability to attract and draw funding from investors to expand and grow[1]. Prior to the decision for investors to provide their funds in a particular company, they will want to be certain that the company is financially stable and will continue to be so in the expected future. Investors therefore need to have assurance that the company is being well managed and will maintain its profitability.

In order to have reassurance, investors look towards the published annual report and accounts of the company and to any other information disclosures that the company might make. They presume that the annual report and financial records will present a true representation of the company’s current position. These annual report and financial records are subject to an annual audit where an independent auditor observes the company records and transaction entries, and certifies that the annual report and financial records have been prepared in accordance with Generally Accepted Accounting Standards (GAAP) and give a ‘true and fair view’ of the company’s activities[2]. Nevertheless, although the annual report can give a reasonably accurate representation of the company’s activities and financial position at the present time, there are many sides of the company that are not effectively and successfully portrayed in the annual report and financial records.

There have been numerous high profile corporate collapses in the past that have arisen regardless of the fact that the annual report and financial records seemed fine. For example H.I.H., Enron, One. Tel etc[3]. These corporate collapses have had an unfavourable effect on many stakeholders: shareholders who have seen their financial investments reduced to nothing; employees who have lost their jobs and, in many cases, the safety of their company retirement fund, which has also dissipated overnight; suppliers of goods and services to the unsuccessful companies; and the economic effect on the local and international communities in which the company operates in. In fundamental nature corporate failure and collapses affect us all. Why have such collapses occurred? What might be done to prevent such collapses happening again? How can investor confidence be restored?

Corporate Governance

The answers links to corporate governance: a lack of effective and efficient corporate governance meant that such collapses could occur; however, good corporate governance can assist in preventing such collapses happening again and restore investor confidence. Corporate governance includes the “structures, systems, cultures and processes that stimulate the successful operation of organizations and systems to cope with these elements”[4]. Corporate governance also includes the relations between the various stakeholders involved and the goals and objectives for which the corporation is administered[5]. The major stakeholders involved are the shareholders, management, and the board of directors. Stakeholders may also include customers, employees, suppliers, creditors, regulators, and the society at large[6].

Agency Theory

An important subject matter of corporate governance is to ensure the accountability and responsibility of certain individuals in a corporation through means that try to lessen or eliminate the principal-agent problem. The agency theory explains the relationship between the principal(s) and the agent(s)[7]. As applied to corporate governance the shareholder is depicted as the ‘principal’ and the problem, following the separation of ownership and control[8] is how the principal can guarantee that his/ her ‘agents’ (which are company directors or managers) will serve the shareholders interests rather than their own. Either by lack of attention to maximize shareholder wealth, or in terms of ‘self-interested opportunism’ – accruing wealth to themselves rather than shareholders – the principal is vulnerable to the self-interest of their agents[9].

Corporate governance intends to control and resolve problems and issues that arise from principal-agent relations, where owners have an interest in increasing the value of their shares; whereas managers tend to be further interested in the private spending and use of company resources and the growth of the company[10]. It addresses such problems through the contract drafting process and others measures and mechanisms which are developed. One way to contribute to effective corporate governance efforts in addressing the agency problem is the independent director’s involvement.

Independent Directors

An external or independent director is a non-executive director of the company who; apart from getting director’s compensation, does not have any material economic relations or business transactions with the company, its senior management or its holding company, its promoters, its subsidiaries and allied companies; is not associated to promoters or management at the board level or at one level below the board; is not employed or previously employed as executive of the company in the previous three financial years; is not a partner or an executive of the internal audit company that is associated with the company, and has neither been a partner or an executive of any such company for the last three years; is not a supplier, customer, or a service provider of the company; and is not a substantial shareholder of the company.

Early work by Fama and Jensen [11] argued that independent directors offer a means to supervise management operations and activities through an improved focus on company’s financial performance. Pearce and Zahra [12] supports this view, that there is a positive link between the amount of independent directors and company financial performance. Similarly, Lee, Rosenstein and Rangan [13] support this view, providing evidence indicating that boards majorly subjected by outside/ independent directors are associated with improved returns than those subjugated by internal/ executive directors. Baysinger and Butler [14] also describes that adjustments in board structure over a ten year period from 1970-80’s suggests that there is a causal link with accounting performance. Furthermore, Millstein and MacAvoy [15] found that there is a significant relationship amongst active, independent boards and higher company performance.

To enhance the effectiveness of the corporate governance, it must comprise of an independent board of directors as stated under the Corporate Law Economic Reform Program Act 2004 (CLERP 9). Conversely, independent directors will not function efficiently and effectively if several essential principles are not met. There are five important aspects to that make up the nature of an independent director. These include independence, remuneration, knowledge and qualification, assurance, and autonomy. Application of these aspects ensures effective corporate governance.

Independence

First and most important, is the independence of directors. The ‘Principles of Good Corporate Governance and Best Practice Recommendations’ (Principles) recommends that a majority of directors are independent[16]. The purpose of introducing an independent director is to present objective and independent judgement on management’s performance, whilst not being influenced by the company’s management or major shareholders. In some companies, where there are significant insider control and governance issues, for independent directors to examine a company’s major associated transactions exclusive of minority shareholders’ interests being infringed, the fundamental characteristic of independence must be satisfied[17]. In essence, directors must be independent from management, as well as from the controlling shareholder. They are not truly and fairly independent if the independent director(s) have any close relationships with either party, both agent or principal. As a result, independent judgement and fair view is not likely to be conveyed, and the interests of minority shareholders are unlikely to be rightly protected. In contrast, the actions of an independent director will adhere closely to GAAP provided that he or she is acting impartially. Therefore, independence is the requirement to ensure an unbiased and impartial position which in turn creates effective corporate governance practice.

Remuneration

Secondly, through motivation theory, money is essential and it has an express impact on satisfaction [18]. In many companies, directors’ remuneration is often paid in two components, one of which is a fixed fee and the other is often related with the company performance, such as share options, so that to better correlate directors’ interests with that of shareholders. The more revenue an independent director obtains from his job, the more efforts he is likely to put in[17]. Consequently, an independent director will work more effectively for better remuneration (share options), whilst aligning with the interests of the shareholders (shareholder wealth), without the purpose being diluted, thus further supporting good corporate governance practices.

Knowledge and Qualification

Thirdly, sufficient knowledge and understanding is necessary in order for independent directors to make rational and reasonable judgement. With the responsibility of independent directors’ in relation to handling company’s related party transactions, their understanding of the business environment, markets, product and key financial information is essential. Otherwise, they can easily be subject to manipulation by the company or unknowingly making irresponsible material decisions. However, it is argued and supported by Rosenstein and Wyatt[19], that non-independent directors are more effective than independent directors because they have superior knowledge about the company and the industry. In contrast therefore, it is suggested that for independent directors to contribute effectively towards corporate governance, relevant and appropriate training must be given and experienced and qualified foreign abilities and talents should be encouraged. As a result, an independent director can provide untamed insights, other qualifications, foreign experience, and innovation.

Assurance

Fourthly, studies suggest that Director and Officer (D&O) liability insurance is optimistically and effectively related to shareholder wealth [20], and the D&O insurance would effect in a higher percentage of external directors in which to improve and enhance board independence [21]. Without such legal assurance, conventional management is likely to result and shareholders’ wealth and interests is less likely to be secured and protected [22]. Thus, in the absence of D&O liability insurance, it is hard to expect independent directors to participate in an active role. To ensure that independent directors present objective judgment, it is probable that they may well need to rise up and against management’s decisions, so adequate assurance must be given.

Autonomy

Lastly, for independent directors to operate and function properly, autonomy is necessary. Autonomy however, can only be useful and practical provided that the external directors are truthfully independent. Without independence, the higher the autonomy, worse performance may result. Take for example, a parent company sells its’ own merchandise to a listed company at a specially high price or obtained remarkable quality goods from a listed company at an irrational and unreasonable low price, which caused the listed company to soon become financially troubled[23]. Clearly, the independent directors did not play an independent, effective, and reasonable role considering they have the official right to first approve and endorse the business transaction before it is to be submitted to the board. Therefore, in order for independent directors to act and perform effectively as well as support corporate governance practices, strong autonomy must be given.

Conclusion

Furthermore, corporate governance aims to resolve the principal-agency problem. One important aspect to support corporate governance is the involvement of independent directors. There have been several studies that support such independent director involvement to be a positive result to company performance. In addition, there is causal relationship between independent directors and effective corporate governance. The nature of independent directors entails five important contributing factors for effective contribution to corporate governance.

Independence is an important aspect as it provides an impartial and unbiased view and insight to the company. This aspect is the underlying foundation that separates an executive director with an independent director. Remuneration is another aspect in which is not based on self interest, but rather the interests of shareholders. This further supports corporate governance, in which by having independent directors acting on behalf of shareholders interest and in particular, minority shareholders interest, the system in which the company is being governed by, is adhered to. In addition, the qualification aspect poses that an independent director will bring in foreign experience and talents which insider executive directors may not have. This achieves the purpose of introducing an independent director, as an individual with an untamed and undiluted mindset. Consequently this gives rise to assurance, which in essence, disables or reduces an independent director from acting in relief of his/ her duties. Similarly, an autonomous independent director will act morally and for the interest of the shareholders, whether it be decisions with the other executive directors or against. Overall, through the execution and fulfilment of the five aspects, an independent director will be better motivated, have a higher sense of responsibilities, and as a result contribute to effective corporate governance.