Research proposal on the contribution of non-executive directors and ascertain what more might be done to strengthen the quality, independence and effectiveness of non-executive directors
There is no statutory definition of a non-executive director. Non-executive directors are however generally regarded as those directors who, unlike their executive colleagues, do not hold any executive or management position in the company in addition to their role as a member of the board. Like other directors of a company, non-executive directors have to comply with the duties of directors which have been established by common law and case law, such as the duty to exercise care, skill and diligence (Higgs, 2002).
Many see non-executive directors (NEDs) as the solution to most of the corporate problems characterized by Enron, WorldCom, Equitable Life, MyTravel and Vivendi (Moxey, 2003). Yet before these debacles, most people, including a lot of directors, were not sure what non-executive directors were for. Most people in the corporation described them as little more than decorations on a Christmas tree. Since Enron, there now seems to be a growing consensus that NEDs are a mixture of policemen and guardians of shareholders’ interests. This view ignores the fact that NEDs also have an important strategic role. It also wrongly assumes that NEDs have a different responsibility, from that of executive directors in respect of a company’s shareholders.
This brings into light the need for companies to have truly independent directors, strong audit committees, an outlet for whistleblowers and tight controls on share options. At the heart of the Enron scandal is a failure of corporate governance, which among other things, had a board that was ineffective in supervising senior managers' actions, and ignored or whitewashed whistleblowers' complaints. These failures are all too common. Similar lapses can be found in most other big corporate scandals. And they exist, too, in companies where there are no scandals, merely poor performance or entrenched mediocrity. Effective corporate governance is the only way that investors can protect themselves against executives who make mistakes and seek to cover them up. It is the framework that allows internal whistleblowers to be heard and strengthens outside auditors in dealing with management. It gives meaning to the shareholders' ownership of the company.
Interestingly, although the structure of the board at Enron was well supplied with non-executive directors, there was no clear leader and no effective check on the actions of the executive management. There were also questions over how independent the non-executive directors could be, given their involvement in consultancy for the company, or the dependence of their other interests on Enron's benevolence. In the US, the structure of the board consists of non-executive directors with only the chairman and chief executive representing management, making this set-up potentially vulnerable to manipulation of information to directors. A wider representation of top management on a board with a majority of non-executive directors, led by a non-executive chairman or a senior "lead" independent director, seems to be the best formula. It balances the need for strongly led external supervision with the ability of board members to learn about the inner workings of the company. However, non-executive directors will need to spend more time learning about the company, talking to employees and shareholders and reading up about the industry, which will require time and higher pay.
Non-executive directors play a central role in corporate governance among companies. From the point of view of productivity and competitiveness, the progressive strengthening of the role of non-executive directors is strongly desirable. The Enron scandal emphasizes the crucial role non-executive directors play in making board decisions that are helpful in putting out the truth of the company’s real business standing out in the public. This role is both pivotal and vital to the continued public and shareholder trust in big business.
Statement of the Problem
The crucial roles played by non-executive directors in improving company performance and accountability and their role in strengthening corporate governance is widely recognized. Nevertheless, there has been considerable debate about the role played by non-executive directors. This study aims to establish a clearer picture of the way boards operate today, and the contribution of non-executive directors. It will seek to identify what more might be done to strengthen the quality, independence and effectiveness of non-executive directors.
Specifically, the study will investigate the credentials and the track records of the individuals sitting as non-executive directors; find out their expertise in relation to their particular committees or the overall board; account for the amount of time they spend on the company’s business; measure their scope of influence as well as determine the number of other directorships they are serving; examine the relationship between their pay and performance vis-a-vis power and influence; scrutinize their relationship with the CEO; and ascertain the ratio of non-executive to executive members on the board.
Nature and Significance
There have undoubtedly been improvements in the role and effectiveness of non-executive directors over the last decade, as companies' corporate governance arrangements have increasingly come under scrutiny. Much of this improvement is attributable to the development and subsequent refinement of the Combined Code. This was the culmination of work initiated by Sir Adrian Cadbury's Committee in 1992, and supplemented by the Greenbury Review in 1995 and the Hampel Review in 1998 (Higgs, 2002). The Code sets out best practice, for example on board and committee balance, including the role of independent non-executive directors. Listed companies have to report on how they apply the Code's principles and to state whether they comply with the detailed provisions and, if not, why not. The Financial Reporting Council now has responsibility for overseeing the Code. Two recent reviews are also of relevance to this Review. The independent Company Law Review (CLR), whose final report was published in July 2001, made wide-ranging proposals to simplify and modernize company law. The CLR proposed that a general statement of directors' duties should be set out in legislation. The British Government is currently considering the CLR recommendations. The Myners Report looked at investment decision-making in the UK. The Government is considering how to take forward proposals to strengthen the duties of institutional investors.
As regards the role played by non-executive directors, the Cadbury Committee made the following observations:
"Whilst it is the board as a whole which is the final authority, executive and non-executive directors are likely to contribute in different ways to its work. Non-executive directors have two particularly important contributions to make to the governance process as a consequence of their independence from executive responsibility. Neither is in conflict with the unitary nature of the board.
The first is in reviewing the performance of the board of the executive. Non-executive directors should address this aspect of their responsibilities carefully and should ensure that the chairman is aware of their views. If the chairman is also the chief executive, board members should look to a senior non-executive director, who might be the deputy chairman, as the person to whom they should address any concerns about the combined office of chairman/chief executive and its consequences for the effectiveness of the board. A number of companies have recognized that role and some have done so formally in their Articles.
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."
The Hampel Review, six years later, observed:
"Non-executive directors are normally appointed to the board primarily for their contribution to the development of the company's strategy. This is clearly right. We have found general acceptance that non-executive directors should have both a strategic and a monitoring function. In addition, and particularly in smaller companies, non-executive directors may contribute valuable expertise not otherwise available to management; or they may act as mentors to relatively
inexperienced executives. What matters in every case is that the non-executive directors should command the respect of the executives and should be able to work with them in a cohesive team to further the company's interests."
The effectiveness of the nonprofit Board of Directors can be enhanced by regular assessment of its activities and performance. An assessment process can help board members to understand their role, and encourage fulfillment of board responsibilities. The process need not be complicated; it can placed on the agenda of a board meeting, or occur regularly within board meeting discussions through questions that serve to refocus the board on larger issues. For example, a useful strategy is to conclude board meetings by asking board members to rate the meeting on an index card: Were the issues covered today significant? Did the materials you received prior to the meeting adequately prepare you to participate in the discussion? Did the board conduct matters of management or policy? Overall, was the meeting worth your time? A steady stream of feedback created by these responses and used by the board chair and executive director can greatly improve the value of board meetings.
An annual board assessment gives each board member the opportunity to evaluate the board's overall effectiveness at accomplishing its goals in a variety of activity areas. It can be scheduled to occur during a board meeting, or completed by board members on their own time and returned to the agency. Results of the evaluation can be shared at the next board meeting, and appropriate follow-up then determined. A ranking system reflecting the level of accomplishment within each task may be useful (1= effective performance, 2=adequate performance, 3=inadequate performance, U= uncertain), and activities can be grouped into the following categories: knowledge of board financial, legal and public responsibilities; representation to the public by the board; understanding and communication of the organization's mission; organization's compliance with legal regulations, licensing and other standards; effectiveness of board practice: Bylaws, committees, procedures, approval of outside counsel (legal, accounting, managerial); relationship with the Executive Director; hiring, evaluating, managing, and compensating the Executive Director; strategic planning; policy development and approval; oversight of organizational financial structure and activity, including income, expenses, borrowing, insurance coverage, audits, bank relations, fund-raising, and other financial procedures; board performance: meeting attendance, discussion participation; board succession and nomination process; and new board member orientation.
Undoubtedly, the NEDs have both a strategic and a monitoring role. Their effectiveness in their monitoring role needs to be improved, but without impairing their effectiveness in a strategic role. The NEDs’ monitoring roles include: bringing external and independent influence to bear on issues such as financial performance, risk, internal control, standards of conduct, compliance, probity and the evaluation of management and board performance; deciding the remuneration of the executive directors (EDs); effecting changes in board composition when governance or performance issues suggest that this is necessary, but it is unlikely to be initiated by the EDs, and making recommendations to shareholders on the appointment of auditors. The last three functions should be carried out without the involvement of EDs.
Moreover, NEDs should act as the “corporate conscience” in respect of corporate social responsibility issues. As the issue of corporate social responsibility (CSR) rises up the business agenda, it is appropriate for NEDs to accept a responsibility for ensuring that social, environmental and sustainability issues receive an appropriate degree of board level attention. NEDs should also be sensitive to the public interest issues inherent in balancing long-term sustainable growth with the short-term financial demands associated with the recruitment, retention, motivation and reward of the EDs.
Furthermore, NEDs should exercise individual judgment, but they should act primarily through the board or in committees rather than individually. NEDs would become more like EDs if they regularly made decisions on their own which committed the company, or would be likely to do so.
Moreover, NEDs should prepare their own governance report to shareholders, as part of the annual report. This report should explain how NEDs consider that they have fulfilled their monitoring role, and should cover the work of the non-executive committees such as the audit and remuneration committees. Through the audit committee, NEDs should give prior approval to any non-audit work to be carried out by the external auditors, and they should regularly assess the independence of the auditors. The audit committee should disclose its assessment of the independence of the auditors, and the reasons for awarding any non-audit work to the auditors, as part of the NEDs’ governance report. Trends in the balance of audit and non-audit fees should be monitored and significant changes fully explained.
Purpose of the Proposed Project
The current thrust of corporations for corporate governance places a big responsibility on non-executive directors to play a vital role in their companies’ respective board of directors. This project intends to identify the contribution of non-executive directors and ascertain what more might be done to strengthen the quality, independence and effectiveness of non-executive directors. The need for this appraisal of their roles and responsibility to the business community comes in the heels of corporate scandals in the US wherein they were found to be lacking in independence and instead, kowtowed to the common denominator. By taking a closer look at these individuals, this study hopes to come up with strong guidelines and recommendations for companies to follow when they hire non-executive directors. Moreover, it could serve as a guide for existing non-executive directors in the discharge of their duties.
The researcher has divided the following research questions according to role, attracting and appointing non-executives, structures and accountability, relationships with shareholders and others, and support.
What role should non-executive directors perform, and how does this compare to the present position?
Possible issues for comment:
1. What is the role of the board? What is the role of the Chairman and how does it relate to the non-executive directors?
2. What should be the key roles of non-executive directors on the board and what should be the balance between the different components? Within a board, should all non-executive directors be expected to fulfill each of the different roles?
3. How does this compare to the present position?
4. How independent do non-executive directors need to be for the different roles?
5. What are the main potential conflicts of interest which may arise within a company where non-executive directors can play a role in protecting the interests of the company? What can be done to help non-executive directors to be effective in relation to these conflicts?
6. What time commitment is needed for the role of Chairman and for non-executive director roles, and how far does this vary between different companies? Are there any implications for the number of non-executive posts that one person can sensibly take on?
7. Should there be a special role for a "senior independent" non-executive director?
8. Do you have comments on the proposed statutory statement of directors' duties, which does not seek to distinguish between the legal duties of executive and non-executive directors?
B: Attracting and appointing non-executives
What knowledge, skills and attributes are needed, and what can be done
to attract, recruit and appoint the best people to non-executive roles?
Possible issues for comment:
9. What are the key skills, knowledge and experience which are needed by non-executive directors to perform the role effectively, and how is this likely to change over the next, say, 10 years? Are some skills essential and, if so, what are they?
10. What personal qualities and attributes are needed?
11. What sort of mix of experience and attributes is desirable on a Board? Specific examples of cases where non-executive directors have contributed with particular effect to company performance, or to corporate governance, would be helpful.
12. How easy is it to recruit non-executive directors with the right skills and attributes? Could recruitment and appointment mechanisms, including Nomination Committees, be improved?
13. What could be done to widen the pool of potential non-executive directors and introduce greater diversity into appointments? What are the constraints on this? Is there scope for greater international representation on UK boards?
14. Are the rewards for non-executive directors appropriate, both in terms of levels of pay and the form that remuneration takes e.g. cash/shares/share options? Are current pay levels a significant factor in whether good non-executive directors can be attracted?
15. Do you have comments on the issue of risks or insurance provision for non-executive directors?
C: Structures and accountability
Do existing structures and procedures facilitate effective performance by non-executive directors?
Possible issues for comment:
16. How is the Combined Code working in practice? In particular, how are the provisions on the balance between executive and non-executive directors and the role of independent non-executive directors working? Is further definition needed of independence in the Combined Code and, if so, what would a sensible definition be?
17. Do the recommended structures for board committees facilitate governance and an effective contribution by non-executive directors? Are board meeting procedures working effectively? Do you have comments on board size?
18. Do you have comments on the composition and duties of Audit Committees? How effectively are Audit Committees working in practice? Do you see a need to strengthen the existing Combined Code provisions on Audit Committees?
19. Similarly, do you have comments on the composition, duties or operation in practice of Nomination and Remuneration Committees?
20. What processes are in place for setting objectives and reviewing performance against those objectives, for the board as a whole and for individual directors?
21. Could more be done to review performance? Should more information on board performance be reported to shareholders? Should companies provide more information on the performance of non-executive directors?
22. Are non-executive directors able successfully to challenge executive decisions or expose serious problems? Should it be made easier for them to do so and, if so, how?
D: Relationships with shareholders and others
Do existing relationships with shareholders or others need to be strengthened?
Possible issues for comment:
23. How well do relationships between non-executive directors and shareholders and stakeholders work, and could they be improved? For example, the researcher is interested to hear views on what the relationship might be between non-executive directors and institutional shareholders. How could this relationship be strengthened?
24. To what extent are Chairmen creating the conditions for non-executive directors to be effective? Is there more that they could do, by promoting constructive relationships, managing the discussion processes, encouraging challenging and effective contributions in board meetings and ensuring appropriate information flows, or otherwise?
25. What should be the relationship between non-executive directors and executive directors, and with senior management? What should their relationship be with the Chairman and the Chief Executive? What should their relationship be with key advisers to the company?
26. How can Company Secretaries support effective performance by non- executive directors?
How can non-executive directors best be supported to perform their role?
Possible issues for comment:
27. How much access to information from management do non-executive directors need to be effective? In practice, are information flows and communication channels sufficiently open and unrestricted?
28. What training and development opportunities are available? Could they be improved and, if so, how?
29. Can induction for non-executive directors be improved?
30. Do non-executive directors get clear guidance on what is expected of them and do they get feedback on whether they are meeting expectations?
1. Get a copy of the board of directors of twenty (20) different companies engaged in different types of businesses.
2. Identify the non-executive directors in each board.
3. Ascertain the ratio of non-executive directors with executive directors.
4. Interview or survey these non-executive directors according to:
- the current roles they play,
- their credentials and their track records
- their level of expertise in relation to their particular committees on the overall board?
- the amount of time they spend on the company’s business
- the scope of influence of non-executive directors in the boards and companies that they serve in
- the conflicts of interest, if any, that exist between non-executive directors and the consulting work that they do for the companies where they sit on the board
- the other directorships non-executive directors serve in
- the relationship of non-executive directors with the company CEO
5. Determine the existence of statistical significance in the relationship between the pay and performance vis-a-vis power and influence of the non-executive directors
Moxey, Paul. (2003). ‘The Way Forward For Non-Executive Directors’. The Association of Chartered Certified Accountants. (January 8, 2003). Available from: http://www.acca.co.uk/publications/accountingandbusiness/802520. Accessed [01/15/03]
The Financial Times Limited; Financial Times (London); February 19, 2002, Tuesday; London Edition 1
Higgs, Derek. (2002). Review of the role and effectiveness of non-executive directors. Consultation Paper. Available from: www.dti.gov.uk/cld/non_exec_review/condoc.pdf Accessed [01/15/03]
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