Corporate Governance, Role of Non-Executive Directors - Essay Example

?Introduction A non-executive director of an organization is not a part of the management of the organization. What distinguishes a non-executive director from an executive director is the fact that he or she is not an employee of the organization neither is related with the organization in any other manner. This therefore relatively gives non-executive directors (NED) independence to view and develop a different insight about the affairs of the firm. The presence of a NED provides board a balance in terms of voicing the concerns of all stakeholders while at the same time maintain independence of the board as a whole. It is critical to understand that NED is different from independent directors as NED can own shares of the firm whereas independent directors need not to have the shares. It is critical to note however, that the overall independence of NEDs is often based upon two important criteria of exercising independent business judgment and non-subservience to any influence of the management of the organization. (Cray, 1994) One tiered board of directors are unique in the sense that the overall control of managing directors of the firm is in the hands of a different supervisory board whereas in two tier system this is an additional responsibility of the existing board of directors. Over the period of time, the role of NEDs has increased specially in single tiered boards with non-executive directors taking independent view of the overall governance mechanisms within the organization. This paper will review the role of non-executive directors in single tiered boards and how it has evolved over the period of time. Corporate Governance Before discussing the role of non-executive directors and how their role has evolved during the recent past, it is critical to present an analysis of corporate governance. The issue of corporate governance and how companies should be governed started to emerge after the large scale corporate scandals of Enron and WorldCom. The recent failure of financial institutions and resulting economic downturn has further fueled the debate about whether the companies are being managed in their right sprit or not. The losses incurred by shareholders due to practices of managers therefore outlined that corporate governance should be strengthened while at the same time ensuring that companies meet a certain criteria against which their performance is measured.( Gay, 2001) Corporate governance therefore emerged as a system to control and direct firms. It therefore not only defines the relationship of firms with that of the shareholders but with the employees and other stakeholders also. Corporate governance as a mechanism also outlines ways and means through which the conflict of interest between different stakeholders is actually prevented. By setting out clear and vivid boundaries for each of the stakeholders, corporate governance provides a mechanism through which the interests of each stakeholder are monitored and governed. It is also important to note that recent debate has also focused on the overall economic efficiency of implementing corporate governance and whether the implementation of corporate governance codes is just a cost or it could also lead to the benefits for all the stakeholders also. Corporate governance as a mechanism is based upon certain principles which govern as to how the corporations should be governed while the stakes of all the stakeholders are protected. First principle outlines that firms should give right and equitable treatment to shareholders suggesting that organizations should develop mechanism to facilitate the rights of the shareholders and how such rights can be exercised. It also suggests that the interest of other stakeholders such as creditors, debtors, government, employees and society as a whole should also take into consideration when managers manage the firms. (Hall, & Liebman,1998). One of the key and most important principles outlined by the corporate governance is the roles and responsibilities of board of directors. Corporate governance codes have specifically outlined and enhanced the role of board of directors and how board as an independent body should oversee the supervision of the firms. Directors of the firms have been made accountable to ensure that they develop certain insight and analysis of the overall governance within the organizations and what steps can be taken in order to ensure that interests of all the stakeholders are protected. Corporate governance further outlines that the board should have relevant skills and abilities to basically challenge management practices. In order to achieve this objective, it therefore requires having adequate size and the independence so that it can exercise what is right and can protect the interests of the shareholders and other stakeholders involved in the overall affairs of the firms. Corporate governance models Since corporate governance can have legal implications for the firms therefore the overall models which are being practiced in different countries and regions are different. These models primarily differ in terms of what kind of capitalism is being exercised within the country. There are therefore critical differences in the models exercised in continental Europe, US, UK and Japan. The corporate governance models which are being used in US and UK are based upon single tier system whereas boards in countries like Germany and Japan are two tiered in nature. Two tiered boards often take into consideration the rights and interests of stakeholders other than shareholders of the firm including workers, society, government and other stakeholders. The Anglo-Saxon Model which is being practiced in US and UK is based upon unitary system with board having the major responsibility of ensuring that interests of shareholders are secured and protected. It has also been suggested that companies where Anglo-Saxon model of corporate governance is practiced are relatively larger as compared to firms where two-tier system is being followed. Such large nature of the organizations along with the fact that there are large number of shareholders involved make it relatively important for directors to protect the interests of the shareholders. It is also critical to note that the laws of the State are also applicable on these firms therefore there exists a dual system of regulations governing the overall conduct of the firms. Corporate governance however, is relatively internal governance mechanism set up by the organizations. Single Tiered Boards One of the major corporate governance differences between the firms is that of the structure of the board. This structure, as discussed above can be either dual or unitary in nature. Under unitary board system or single tier boards, there is only one board of directors with participation from both the executive as well as non-executive directors with non-executive directors forming the larger part of the board. Single tiered board is held responsible for all the activities of the firm and the directors therefore usually work towards the achievement of such goals. It is critical to note that the election of shareholders take place at the annual general meetings of the firms and directors are elected by the shareholders. (Pass, 2004) It is also argued that the single tiered board can actually suffice if non-executive directors can exercise their powers independently. The overall concerns of shareholders can be safeguarded if the board members are entrusted with the responsibility to safeguard their interests at all costs. An independent board with sufficient skills therefore can easily serve the purpose of shareholders without having the need to appoint a separate board which can actually increase the overall costs for the shareholders. Single tiered boards have more effective due to the active participation of non-executive directors. The basic difference between the single and two tiered boards therefore is based upon the overall degree of responsibility held by the board members. In single tiered boards directors have to have enough insight and skills to oversee almost every aspect of the management and ensure that the management practices are according to acceptable norms. In such a system the role of non-executive directors play really critical role because they remain under no influence and can exercise a degree of independence. During recent times the overall role of non-executive directors has become critical due to the recent corporate scandals. Shareholders now view non-executive directors as important board members who can ensure that the overall interests of shareholders are protected under all costs. Non-Executive Directors As discussed above, a non-executive director is not a part of the management of the organization however he or she is considered as an outside director. With no association with the management of the firm, a non-executive director seems to enjoy certain degree of freedom and independence as compared to executive directors. (Mellor, 2001)  In UK, non-executive directors have specific responsibilities including challenging and constructing the strategies for the firm. NEDs are also required to critically evaluate the performance of management and should develop critical insight into various management areas to actually challenge different management assumptions. One of the key responsibilities of non-executive directors is also based upon evaluating the financial information and develop insight into the risks involved in the overall systems and controls of the organization. NEDs are also being entrusted with the responsibilities for determining appropriate level of compensation for management while at the same time taking part into the succession planning for top level executives of the firm also. (O’Regan, et al. 2012) Role of Non-Executive Directors Historical role of non-executive directors has been that of stewardship and monitoring of the overall affairs of the firm. The overall concept of separating management from the ownership of the firm therefore suggests that non-executive directors must have to play the role of stewardship and monitor the interests of the shareholders. This traditional role of non-executive directors however, has evolved over the period of time and in the wake of new corporate scandals, there has been a growing emphasis on the new roles and responsibilities to be assumed by the non-executive directors. It has been argued that under Anglo-Saxon governance model, unitary board is considered as one of the essential features of overall governance mechanism. However, corporate scandals in past and the current economic crisis have really raised questions over the role of non-executive directors and whether they have been performing this role quite diligently or not. There has been a growing concern over redefining the role of non-executive directors. Earlier, it was believed that non-executive directors should act as delegated monitors with the responsibility of overseeing the interest of the shareholders. The role of non-delegated monitors therefore outlines that the non-executive directors must look into certain issues which shareholders may not be able to oversee on their own. It is however, argued that the higher level of ownership by the management of the firm often reduces that role of non-executive directors because by having higher shareholding, management holds relatively higher discretion in the overall decision making process at the board level. This role of non-executive directors therefore require them to monitor the overall performance of the managers however in order to do so they must have some sort of financial interests in the firm. One of the key arguments on the failure of non-executive directors to actually fulfill their responsibility to monitor is due to the lack of their financial interests in the firm. There is also a growing emphasis on acquiring financial skills and ability to actually monitor financial information and performance of the firm. There is a growing debate on the argument that non-executive directors must develop the skills to understand and question different financial decisions made by the management of the firm. The lack of skills to interpret the financial information correctly therefore offers a very important insight into the role of non-executive directors. (Treadwell, 2006) It has also been argued that the non-executive directors must have some sort of financial interests in order to have higher level of incentive to monitor the performance of the management. Lack of financial interests in the firm therefore makes it relatively less beneficial for the non-executive directors to successfully monitor the performance of managers. Many therefore argue that non-executive directors also must have a certain degree of equity participation in the firms to raise their stakes in the success or failure of the firms. Higg’s Report based on the commission made by British Government has also further outlined the new roles and responsibilities of non-executive directors of the firm. One of the key responsibilities which also indicate a shift towards new roles of non-executive directors is to achieve balance between revenue and stability of the firm. Non-executive directors have the clear responsibility of ensuring that the growth in revenue of the firms is managed at acceptable level while the overall stability of the firm also remains at desirable level. This new role therefore outlines that the non-executive directors need to ensure that revenue of the firm remains at acceptable level while managers must not take any actions which can put stability of the firm in question. (Steele, 2008) Earlier, the role of non-executive directors has been limited to the monitoring of the managers but it also now requires that the non-executive directors must also have role in the strategy development. Non-executive directors need to have cross-sector experience therefore must have the role in strategy development and challenging the strategic role of managers. This role of non-executive directors requires them to participate actively in the strategic management process. This would require that the role of non-executive director to be based upon challenging the different strategies made by the managers and determine correct course of action which can safeguard the overall interests of the shareholders and other stakeholders of the firm too. It is now also been expected that the non-executive directors bring in the leadership aspect in the overall affairs of the board also. Since non-executive directors come from diverse background and having their own business expertise, it is now expected that NEDs must also play their role in enhancing the overall effectiveness of the leadership within the organization. This will require them to mentor the managers and providing them strategic insight into what a leader should do under different circumstances faced by the firms. (Deakins, O’Neill, & Mileham, 2000) Role of non-executive directors also require to have them business experience and expertise. This aspect may be relatively different from the stewardship role however, it can corroborate this. Non-executive directors having rich business experience tend to offer challenge as well as change in the overall board decisions and add more variety to the managerial practices. (Boussouara, & Deakins, 2000) There has been a growing emphasis on the compensation of non-executive directors also as it has been indicated that academic literature is relatively silent on this issue. (Hahn, & Lasfer, 2008). In order to further improve the role of non-executive directors and increase the incentives for them to monitor and challenge the performance of the managers, non-executive directors must be adequately compensated for the same. (Chambers, 2005) This argument is based upon the notion that non-executive directors in the past have failed to exercise a certain degree of independence in their decisions as well as action therefore it is critical that they must be compensated adequately to increase their overall incentives in monitoring the situation. Independent role of non-executive directors therefore is one of the key to determine as to how their other roles are being evolved and monitored. There has also been debate regarding how much independence to be given to non-executive directors. Independence of Non-Executive Directors The basic principle underlying the overall independence of non-executive directors is based upon independence of their character and judgment. Different corporate governance codes critically outline that the overall independence of non-executive directors can be assessed if they are independent in their judgment and character. Certain issues such as employment with the firm, receipt of any income from the firm, having any material interest in the firm, having family ties with the executive directors of the firm as well as other incentives may hamper the overall independence of the non-executive directors. It is because of this reason that different corporate governance codes specifically restrict non-executive directors to have any such incentives during last few years. The changing roles of non-executive directors also require them to be independent however the question also remains as to what extent non-executive directors should be independent. One of the key questions in this regard is whether independence of non-executive directors can actually hinder the smooth operations of the firm and can hinder the overall discretion of executives and management of the firm. (Lee & Pica, 2010) Non-executive directors therefore can be independent up to the point where their overall work do not materially hinder or obstruct the smooth functioning of the organization and also allow managers to perform their fiduciary responsibilities. Crossing such limits therefore may put questions over the ability of non-executive directors to actually protect the interests of the shareholders. Since a major and clear responsibility of non-executive directors is to assist in improving the revenue of the firm therefore their independence should not hinder the revenue growth for the firm while at the same time ensuring that overall stability of the firm remains intact. Conclusion The overall role of non-executive directors has evolved in the recent past owing to large scale corporate scandals and current economic downturn. Anglo-Saxon model of corporate governance outlines that the firms have only single tiered board of directors with non-executive directors having significant role in overseeing the performance of the firm. The traditional role of non-executive directors was based upon stewardship and monitoring however, it has changed over the period of time. Non-executive directors now seem to contribute towards the strategy making process of the firm while also providing leadership support to the managers. Non-executive directors also must develop the skills and abilities to interest financial information and have the capability to question different management assumptions. Such roles of non-executive directors however require independence outlining those non-executive directors should be independent from the influence of management. However, the overall independence of non-executive directors should not hinder the smooth operations of the firm and must not restrict managers from performing their fiduciary duty to the shareholders of the firm. It is also critical that the independence of non-executive directors must not cross a limit because they also have a responsibility to ensure that the firm’s revenue shows growth. As such the overall independence of the non-executive directors must achieve a balance between revenue growth and stability of the firm. References 1. Boussouara, M & Deakins, D (2000) Trust and the acquisition of knowledge from non-executive directors by high technology entrepreneurs, International Journal of Entrepreneurial Behaviour & Research, 6(4), p.204 – 226 2. Chambers, A (2005) A teddy bears' picnic or the lion's ring? Do non-executive directors add value?, Measuring Business Excellence, 9(1), p.23 – 34 3. 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