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Name: Brian Lee Shun Rong (G14)

Discuss the effectiveness of independent directors in producing good corporate governance.

Independent directors are perceived by the corporate world as one of the most effective solutions to
corporate governance problems. In many countries, the Companies Act, a set of regulations that all
registered companies in the relevant country have to comply with, requires listed companies Audit
Committees to be either mostly or completely comprised of independent directors, on the basis that
they will exercise unbiased judgement when carrying out their duties. However, although
independent directors are in theory, effective for producing good corporate governance, extensive
research has proved that in practice, their effectiveness is limited. This paper seeks to prove this
argument.

According to NASDAQ, an independent director is a person other than an executive officer or


employee of the company or any other individual having a relationship which, in the opinion of the
issuer's Board of Directors would interfere with the exercise of independent judgment in
carrying out the responsibilities of a director. There are two main rationale for companies
employing independent directors to the Board. Firstly, independent directors are perceived as
being able to contribute to better corporate performance. Independent directors can help offer
management an alternative and neutral viewpoint when faced with important business decisions.
Often, companies appoint independent directors with vast amount of experience and expertise in
fields which are of relevance to the company, and with this experience and skills, they will be able
to offer strategic business advice to companies. Secondly, independent directors are viewed as
being able to promote good corporate governance, which generically refers to guarding against

financial manipulation or corporate fraud, and encouraging more transparent corporate reporting.
Companies believe that independent directors, having no motivations to manipulate financial
results, will serve as whistle-blowers to monitor the actions of management, discovering and
preventing wrongdoing which can be detrimental to the company, such as financial results
manipulation or fraud. This is especially important in the case of public companies, where
companies have a duty to their shareholders to ensure that management always acts in the best
interest of shareholders. For years, it has become conventional wisdom that well-managed
companies should have a significant presence of independent directors on the Board. Hence many
public company boards consist of a sizeable number of independent directors, not just because
regulations require them to adopt this practice, but also largely because independent directors help
increase the value of the firm to shareholders.

However, empirical research does not support the theory of independent directors. Years of
extensive research and detailed studies have produced no clear evidence of a positive correlation
between board independence and corporate performance, for some studies have shown positive
correlations while others show no or negative correlations. Studies have not shown that heavy
majorities of independent directors are superior at monitoring companies either. Furthermore,
recent cases of financial fraud such as Enron and Worldcom have not been able to be prevented by
a supermajority of independent directors in their company boards. The head of Enrons audit
committee, Robert Jaedicke, was an accounting professor at Stanford University and thus highly
qualified for the job but still failed to detect the sophisicated fraud by company insiders.

There are a number of reasons as to why the reality differs so significantly from the theory. First,
independent directors may not have any motivation to distort financial statements, but that does not
mean that they have sufficient incentives to prevent fraud or manipulation. It may be argued that
their reputational concerns, and the fact that they are liable for issuance of false or manipulated
financial reports is enough incentive for it to be in their interest to prevent such incidents.
However, in fraud cases, a dishonest management will take every effort to conceal evidence from
the independent directors, and usually succeed in doing so since independent directors generally
lack information about what is really going on in a company, as they are not involved in its direct
management. Therefore, uncovering fraud cases is not impossible, but this would mean that
independent directors would have to put in a lot more effort than company insiders to get the
information essential for the prevention of the fraud. However, most independent directors have
multiple means of employment, often sitting on multiple company boards and thus have
insufficient time to put in the extra effort to gather the information required. The limited time they
can allocate towards one company would mean that they would monitor the company mainly
based on the information given to them by the management, which might not reflect the full
picture. For example, ever since the introduction of the Sarbanes-Oxley Act in the USA, which
made more stringent monitoring mandatory, the time needed for Audit Committee meetings has
more than doubled. Due to their multiple commitments, there is now insufficient time for many
directors to complete their work, and their discussions often end up being truncated or spilling
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over into hastily arranged teleconferences." This adversely affects the effectiveness of their

1 Jay W. Lorsch & Robert C. Clark, Leadingfrom the Boardroom, 86 HARV. Bus. REV. 104, 107 (2008). However, some scholars
indicated that directors have been serving on fewer and fewer boards since SOX, and that would help boards maintain a performance
advantage. See Robert A.
Prentice & David B. Spence, Sarbanes-Oxley as Quack Corporate Governance: How Wise is the Received Wisdom?, 95 Geo. L.J.
1843, 1865 (2007).

monitoring. In addition, independent directors can escape liability by claiming ignorance of the
fradulent actions of management which had been concealed from them, so this reduces the
incentive for them to prevent corporate wrongdoing.

In addition, research has shown that reputational concerns can actually be more of a hindrance than
a help to independent directors monitoring duties. A 2010 study by Fahlen, Low and Stulz has
found that outside directors are more likely to resign from boards when they find that the company
2

is in trouble, to preserve their reputations. Thus rather than perhaps working to prevent a fraud
that they suspect is happening, they would rather leave if they find that it is difficult to gather
evidence to prevent the incident from happening and their reputations going down the drain with
the company.

Second, the current definition of independence specified by company regulatory bodies does not
cover all the potential influences which might affect the directors unbiased judgement pertaining
to matters of the company. Currently the definition specifies that independent directors must not
have any business ties with the company and its management, but overlooks personal relationships.
The key problem is the need or inclination for the independent director to maintain good grace
with the management, thus potentially influencing the effectiveness of the directors monitoring
duties. Friendships between the director and members of the management will undermine the
neutrality of the directors judgement, as when faced with difficult decisions such as exposing the
fraud of a manager, the inclination to maintain friendly ties might affect the directors decision.
While regulatory requirements may be expanded to cover friendships, it would still fail to capture
2 Fahlenbrach, diger, ow, Angie and ene . Stulz,
, The Dark Side of utside Directors Do They Quit hen They are
ost Needed? ECGI - Finance Working Paper No. 281/2010. Available at SSRN: http://ssrn.com/abstract=1585192

friendships that develop between the independent director and management during the course of
his time at the company. Therefore it is very difficult for authorities to ensure that independent
directors are indeed truly independent, and thus would completely and impartially fulfill their
duties.

Finally, the appointment of independent directors poses a key problem to corporate governance.
This is because the director may be inclined to conform to the interest of the manager who
appointed him. In the USA, the appointment process is greatly influenced by management, and
often management would invite favoured candidates for independent director positions who might
be friends of management, thus undermining their independence. Some regulators have recognized
this problem and thus require that independent directors be appointed by an independent
nomination committee. However, the same problem still applies since the members of the
nomination committee are usually appointed by shareholders, and since management are in many
cases, major shareholders, they tend to have powerful voting rights and thus great influence over
who gets nominated. A relevant example is the Sweden Corporate Governance Code, which
dictates that independent directors be nominated by a nomination committee comprising of at least
one independent member. However this committee is nominated by shareholders at the Annual
General Meeting, where major shareholders can determine the members through their powerful
voting rights. Therefore the current appointment process is such that it can be heavily influenced
by management as there are no restrictions on the amount of company shares they can own, and
they might not necessarily act in the best interests of shareholders, undermining corporate
governance.

The reasons given account for the discrepancy between the theory and reality of the effectiveness
of independent directors. It thus disproves the popular belief, supported only by theory, that
independent directors produce good corporate governance. Therefore it shows that companies
cannot rely merely on a majority of independent directors in their boards, and have to seek other
solutions to ensure effective corporate governance.

References:

Wallison, P.J. (2006). All the Rage: Will Independent Directors Produce Good Corporate
Governance?
AEI Online. Retrieved from http://www.aei.org/article/economics/financial-services/allthe-rage-will-

independent-directors-produce-good-corporate-governance/

Chou, C.F. (2013). Are Independent Directors Effective Monitors in Taiwan- A


Theoretical Analysis National Taiwan University Law Review. Retrieved from
http://www.law.ntu.edu.tw/ntulawreview/articles/8-1/2-Articile-ChengFong%20Chou_49-95_.pdf

Gutierrez, M., & Saez, M. (2012). Deconstructing Independent Directors. European


Corporate Governance Institute (ECGI)- Law Working Paper No. 186/2012. Retrieved
from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1986842