Within the academic, government policy, and the popular press circles, the issue of corporate governance has gradually become an issue of rising importance. There is a wide range of reasons that have been offered to explain the heightened attention towards corporate governance. One of the main reasons expressed towards this end is the financial scandals that have shrouded the corporate world.
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Financial scandals affecting major firms such as Arthur Andersen, WorldCom, as well as Enron Corporation resulted in the loss of confidence by investors in the stock market leading to the declining share prices (Fields & Keys, 2003, p.2). Substantial financial losses would not be avoided given the magnitude of the scandals running into billions of dollars.
Typically, corporate governance incorporates the manner in which an organization is managed, overseen, and headed. It takes into consideration the organizational stakeholders including the shareholders, governmental participants, board of directors and the company management (Leblanc, 2005).
Additional participants may include partners, workforce, dealers, professional organizations, clients as well as the society where the corporation functions. Often, the board of directors is impacted on by the operations of an organization. According to the study literature, the impact can be attributed to the significant control over the operations and running of the organization (Bryer, 1993).
When something positive is reported by the organization, all the stakeholders are recognized. However, when something negative emerges regarding the same organization, the board of directors receives considerable blame irrespective of its non-participation in the outcome.
This study critically explores the element of the independence of the board of directors with regard to running organizations in the decision-making structures. The paper highlights and discusses the domain of corporate governance and within it the role of boards. The subsequent section then critically reviews the concept of board independence and its theoretical derivation.
Besides, a review of the empirical literature on board independence, including a summary of findings regarding the impact of board independence on firm performance is also offered. The paper finally concludes with a conclusion in which recommendations are offered on how board independence can be achieved.
State corporation laws and regulations in the 1800s assisted in creating corporate boards. These boards could govern without the unanimous consent of the shareholders, much like the congresses of most states.
Inherent, the running of corporations became more efficient. As the concept developed, the boards gathered more power especially with the inception of huge mutual funds and other cash-building entities (Bryer, 1993). This placed another organizational layer between corporate governors and stakeholders.
Board Structures and Composition
The functioning, structure and composition of the board of directors differ in the type of the board of directors an organization or a corporation has. There are two types of board of directors: the one-tier and two-tier boards.
The Unitary Board
According to Gupta and Fields (2008), this type of board is largely composed of a mixture of an organization’s top management team. In fact, this may include insiders and the organizational executive directors. It also includes outside directors (non-executive).
The unitary board model is popular in the Anglo-Saxon countries including Canada, Australia, Great Britain, USA and New Zealand. Such a board of directors is in charge of defining the corporate goals of an organization, its strategies, as well as operational plans. However, such a board is mandated to nominate, select, and evaluate the chief executive officer.
The board equally proposes the potential board of director members. As part of its accountabilities, this board is responsible for evaluating the performance of the board of directors. That is, it sets the financial goals, performs the monetary control of the organization as well as sets the compensation packages for the organizational managers (Hermes, 2006).
The Tiered Board
Based on Johanson and Ostergren (2010) analytical report, the tiered board seems to be composed of the organization top managers such as the management board together with other stakeholders like the supervisory board.
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Role of Boards of directors
In the circumstances of separation of control and ownership, the interest of the organization managers differs from those of the owner of such an organization. To achieve a balance between the interest of the owner and the managers, it is imperative for the organization to implement various corporate governance mechanisms.
One of these mechanisms is actually the board of directors that act as a link between those who employ the capital like the corporate managers and those who have the capital namely owners (Maassen, 2002, p. 17).
In view of this, the primary role of the executives’ board is making certain that administrators handle affairs of an organization to accomplish the owners’ desires as opposed to meeting their personal desires.
Having been appointed by the shareholders and formed by the owners, the management of the organization is the responsibility of the board of directors in its entirety. In fact, Beecher-Monas (2007) claims that it has a role of ensuring a long-term development of the organization by incorporating diverse interests into balance.
The board of directors in any organization performs this responsibility by acting as the link between a large and varied group that assesses if the organization is successful and a small but powerful group that leads the organization (Nikolic & Eric n.d, p.70). The importance of the boards is acknowledged in the fact that they have a fundamental role to achieve two complimentary but opposing goals.
That is, ensuring that the social responsibility and profitability of the company are realized either in the short run or in the long run. Besides, the boards have the basic role of ensuring the strategic management of the organization.
The boards of directors of an organization are accountable for appointing and monitoring the management while taking adequate responsibility as required by corporate owners (Colaco, Myers, & Nitkin, 2010).
The three key roles of the boards are apparent in the context of the roles of supporting, the strategic role, and the role of control. The role of support refers to the representation of the organization, the establishment of relations with stakeholders, the building of good reputation and the provision of counsel for the organization’s top managers. The control role refers to the appointment, assessing and dismissal of corporate managers.
According to Leblanc (2005), the supervision and control of the managers’ activities occur so that the interests of the owners are duly protected. The problem of positioning the organization in a competitive market is what the strategic role is concerned with to warrant that all organization goals are accomplished.
Considering the increasingly competitive business arena, there is mounting need for the boards of directors to play an active role in defining and implementing the organization strategic processes.
On the other hand, the organization boards of directors also have a role to play in the transition conditions. Beecher-Monas (2007, p.398) claims that this not only means the maximization of the short-term outcomes and the assessment of the managers’ work, but the role should be reflected in the board of directors’ strategic accountability.
It is the responsibility of the boards of directors to define a long-term strategy of the organization, make hands-on decisions, appoint, control, and evaluate the performance of the corporate managers.
Inherently, academic research and corporate governance regulation have increasingly focused on the responsibilities of independent members of corporate bodies (Johanson & Ostergren 2010, p.527). Research on the mainstream corporate governance and best practice codes are usually based on the supposition that autonomous boards are instrumental in the prevention of fraud and ensuring proper financial reporting.
The idea of board independence was a keystone in the prominent Cadbury Report (1992) in the United Kingdom. The concept currently dominates in the corporate governance codes in Europe (Hermes 2006, p.281). In the United States, the corporate scandals that took place in the 2000s such as WorldCom and Enron Corporation strengthened the perceived significance of independent boards.
Contemporary, the NASDAQ and New York Stock Exchange (NYSE) require corporate boards composed of independent members as the majority. The Sarbanes-Oxley Act that was enacted in the fiscal 2002 as a compilation of the requirements to assist in overcoming the multiplicity of inadequacies associated with financial reporting and corporate governance (Gupta & Fields 2008, p.161).
The Act necessitates enhanced autonomy amid the key business entities concerned with the running of an organization namely the auditors, the executive board members, and administrators. The Act sought significant narrowing the meaning of “independent” to mean “absolute autonomy.”
The effort, further supported by the NYSE when it sought to amend the requirement listing which aimed at ensuring the board independence was boosted.
However, in order to improve corporate governance, the NYSE proposed the requirement for any board of directors to consist of the majority of independent directors. Filed by Nasdaq through the Securities exchange Commission (SEC), similar changes took effect in the financial year 2003.
A critical review of the concept of board independence and its theoretical derivation
The idea of board independence is derived from the widely acknowledged and approved financial accounting (economics-based) and agency theory (Johanson & Ostergren 2010, p.528). The field of corporate governance has largely been identical with the agency theory.
The study by Jensen and Meckling in 1976 summarized the primary agency predicament between managers and shareholders in establishing most of currently espoused public corporations.
The study on the organization board of directors revealed that the agency problems that emerge from the separation of control and ownership are dealt with when organizations allocate the “decision management” to the executive team whereas the organization “decision control” is allocated to the members of board of directors.
Besides, the study revealed that such board of directors has the authority to employ staffs, fire human resources, and remunerate high-level decision managers. The organization board of directors also has the power to monitor and ratify critical decisions within and outside organization’s spheres. From this perspective, it remains ambiguous as to whose behalf the board of directors monitors the organization’s management.
Researchers sought to unveil this by conducting studies in the field of corporate governance, as well as in the nature, constitution, and roles of the organization board of directors. The results of the study placed the shareholders of an organization as the residual claimants modeled as the nexus of contracts.
In such a position, the shareholders have a powerful incentive to monitor the management of an organization (Fields & Keys, 2003, p. 2). As claimed by Colaco, Myers, and Nitkin (2010, p.137), this implies that the rights of control be assigned to the organization shareholders.
In their research report, Colaco, Myers, and Nitkin (2010, p.137) claimed that the assertion is because the goal of the organization is to optimize the economic value of the shareholders.
From the existing literature, this could be the main reason, according to Johanson and Ostergren (2010) why corporations should have independent directors who are committed to optimizing the wealth of the organization’s shareholders (p.529). Such directors are conceived as the shareholders’ agent.
Consequently, the fewer links the independent directors tend to have with the management and the organization, the better the performance of such directors in ensuring the protection of the shareholders’ interests.
In the detached ownership structure context, the independent director can be placed in the United States and United Kingdom organizations. Such directors play the central role of protecting the wealth of the shareholder in the absence large shareholders within the organization (Rosenstein & Wyatt, 1990, p. 176).
A review of the empirical literature on board independence
According to academic research, corporate governance codes are rapidly diffused worldwide particularly in the last two decades (Johanson & Ostergren 2010, p. 529). With regard to the obligatory numbers of corporate independent directors, the board composition plays an essential role in the corporate governance codes.
Although the empirical evidence regarding the better performance of organizations presented by having independent corporate boards, the idea of board independence has gradually become a prominent norm. Further, having an independent board of directors does not guarantee that corporate fraud will not occur.
Johanson and Ostergren (2010, p. 529) in their research report indicate that many empirical researches reveal that there is no link between company performance and an organization’s board independence.
Literature shows that this brings the question as to why the independence of board of directors is such an influential norm in the field of corporate governance. Inherently, the idea of having large numbers of independent corporate directors is typically sanctioned by institutional investors.
The idea of independent directors took root in the United States in the wake of corporate fraud in the financial year 2000s including the WorldCom as well as Enron Corporation frauds.
According to the federal and state laws, independence in the corporate context is the absence of the familial tie or substantial financial interest between the company and the board member or the organization’s senior executives and the corporate board member (Nikolic & Eric, n.d). However, the effects and origins of interlocking directorates complicate this.
There are individual directors who tend to suppress various organizations’ management executives. Back door ties depicted by the organizations directors are also common given that they may have been college-mates or colleagues in other organizations. Others may sit in two or more boards with overlapping sets of directors.
This suggests that a purely economic description of independence may not be sufficient in creating the boards of directors that are purely independent of the organization’s management (Zardkoohi & Kang 2005, p. 786). Any social connections with other directors and senior executives can be adversative to the independence of boards and consequently hinder the aptitude of the directors to provide effectual oversight.
Executive pay and decision-making is criticized for being entrenched more in the interest of the executive as opposed to the interests of the shareholders. The oversight role of the board of directors in view of this receives considerable scrutiny. Ordinary wisdom hypothesizes that boards of directors with close relationships with executives and comprise of insiders are more inclined to rubber stamp decisions made by the executives.
They are perceived to give out lavish pays to the executives. Research indicates that a dependent board is more inclined to provide more incentives to executives (Laux & Mittendorf 2011, p. 1467). In turn, the executives are incentivized to forgo their preferred pet projects. This is in favor of projects that are more profitable.
According to Laux and Mittendorf (2011), greater dependence on corporate boards leads to an atmosphere where the executives make efficient selections of projects despite the detrimental and excessive executive rents. The excessive rents inherently points to the dependence of the board as destroying value.
However, the authors state that modest dependence can enhance value when high incentives that come with dependent boards lessen hold-up challenges. The incentives further motivate the executives to think outside the box in finding alternative and profitable projects at the expense of their pet projects.
There are two established methods of determining the independence of corporate boards. In the first method, the corporate boards are required to provide a proper declaration that affirms whether or not every director is independent. The method has gradually become mandatory in most jurisdictions. The board of directors must consequently define the status of every director in accordance with the objective criteria.
These criteria are put forward by the regulating agencies. In determining the independence of the board of directors, it is imperative to consider the factors that are behavioral in nature, personal and qualitative. Rarely, this information is made public.
In another view, instead of looking at independence as a personal attribute, it should be considered contextual (Allaire 2008, p. 9). This means that the view is dependent on concrete decisions and specific cases before the board. The approach is employed by some courts.
In the legal context, independence is founded on a detailed examination of the prevailing circumstances of the transaction or issue. The relationship of the parties involved and the emerging conflicts of interest that are likely to impact decisions to the disadvantage of the shareholders are intensively considered (Maassen, 2002).
Pathways to Leadership
A systematic problem to fraud highlights has more to do with oversight of the process of reporting as opposed to financial reporting processes according to Colaco, Myers and Nitkin (2010). The apparent shortages in the company’s control value point at the organization executives’ duty over the fiduciary lapse.
In fact, the board of directors becomes liable for supervising the implementation of the managerial planned strategies together with the accountability devices. Consequently, the board is a check for the managerial actions. It holds executives responsible and accountable for their action or inaction (Sheridan & Milgate 2005, p. 848).
The level of sovereignty of the board members at the top administration materializes to exert some imperative impacts during the execution of executives’ duties.
Similarly, the commentators note that supervision is enhanced via the autonomy of the executive affiliates given that such associates hardly show enthusiasm to approve the corporation’s administration guidelines. Independent members are more willing to think of the substitute courses of action (Beecher-Monas 2007, p. 384).
In order to promote the independence of boards of directors, it is imperative for organizations to see beyond the ‘narrow’ economic view independence when selecting board members. An imperative antecedent to independence of thought is diversity.
The level of heterogeneity amid the executive affiliates could thus enhance the supervision distinction considerably. This is because people from diverse backgrounds have different perspectives. This means that such people are likely to voice dissenting opinions.
In order to achieve heterogeneity and more independence in the boards, it is imperative for companies to engage more women in the boards of directors. Although the number of females in corporate headship has improved, they are straggling with males during the selection of executives.
Effective corporate governance habitually turns toward characteristics of the corporate board. Even though the typical perception is that, an entirely independent board is desirable for shareholders and has the capacity to promote sound project selections that will closely align with the shareholders’ interests, other factors come into play.
That is, the social relationships established between the organization directors and the senior executives. When boards are independent to the extent that they have control over the corporate compensation arrangements, the autonomy of the board may manifest itself in more prominent incentive pay.
Consequently, this may tip an individual executive’s preferences away from their own projects to more profitable ones. When the model adopted by an organization in managing its affairs involves both project search and project selection, it may result in shareholder benefits.
In the corporate world, independence is an important quality aspect in a variety of situations and in professional behavior. Sometimes, legislation and regulations underpin and enhance independence. Over and above all, directors depend on their organizations in determining whether the boards are dependent or independent.
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