The development of the role of the non-executive directors in a single tier board in recent years, and the expectations from independent non-executive directors

 

Introduction:

Non-executive directors are expected to add a treasured value to the corporate governance effectiveness. They are attracted to bring to the board rich experience, independence, personal quality, objectivity, latest knowledge, reactivity and originality. Thus, their key responsibilities are monitoring and directing business strategy and overseeing senior management. However, because of their vital roles, the corporate governance adjudicators in the UK, and in many others countries, organized the non-executive directors’ responsibilities, roles and remunerations eager to ensure their effectiveness as well as the corporate governance (Solomon, 2011). Nonetheless, in spite of all regulations, rules and codes, Long et al (2005) stated that it is still not easy to evaluate the effectiveness of the non-executive directors and judge the strength of corporate governance in the companies.

Board of Directors

The UK Corporate Governance Code (the Code) (A, the Code, 2010) indicated that each company should be led by an effective board, and this board is collectively responsible for the company success (B, the Code, 2010). Moreover, it determined the roles of the board which are providing a framework to asses and manage risk effectively, set the strategic goals and aligned it with the financial and the human capabilities, reviewing the performance management, set company’s policy to meet the stakeholders’ requirement (C, the Code, 2010; ECGI, 2004).

Consequently, Monks & Minow (2011, p.268) stated that most jurisdictions determine the duties of directors in two points: the care and the loyalty. The care duty means they have to give due diligence before giving decisions, so they have to collect information to answer all the issue’s questions as much as possible, and also consider all available alternatives. Whilst for the loyalty duty they have to express unyielding and un-dividing loyalty to the company, accordingly they shouldn’t manage two inconsistent boards.

However, the board duties are managed according to the board structure, Mallin (2004, pp.161-122) indicated that the major difference corporate governance between countries is the board structure. In view of that, Germany, Austria, the Netherlands and Denmark have the ‘Dual structure’. Thus, the second type, ‘the Unitary’, spreads in the countries which follow the Anglo-Saxon corporate governance style such as the UK, the USA and the majority of European countries.

Moreover, Solmon (2010, p.78) added that the unitary board structure is the most prevalent globally. Generally, Malline (2010, p.162) indicated that both types of board, the Unitary and Dual, have many similarities in their duties, both appoint the senior management, approve the financial report, and ensure the control system and compliance with law.

However, Tricker (2009) classified the board structure according to the directors’ types; the executives and the non-executive directors. So, there are four structures; a board of only executive directors, a board of majority executives, a board of majority non-executive and a board with only non-executive directors. In particular, the boards of only executive directors and the majority of executive directors are mainly found in the small family companies. Nevertheless, the board of only the non-executive directors is found in the public listed company and mostly in the not-for-profit entities “quasi-autonomous non-government organization” in addition to the supervisory board in the dual-tier.

Thus, the forth type; the board of majority non-executives is found in the most listed companies especially in the UK and the USA. Also the executive directors mostly form one third of this board. In the non-executive type almost all the chairmen/Chief Executive Officers (CEO), Chief operating officers and sometimes Chief Financial Officers are the executive members who chair the board. The number of the non-executive members in this board is mostly three or four times of the executive members’ number (Tricker, 2009, pp. 61-65).

Dual (two-tier) board

This type has two boards, the supervisory board that is responsible for monitoring and directing the business strategy and goals in addition to overseeing the management board in the company. All his members are non-executive directors, the chairman of the company sits on this board, and they also have stakeholders’ representatives. Whilst the second board is the management executive board: their members are mostly executive directors and they are responsible for operating the company’s business. Particularly, in the dual structure there is a clear separation between the functions of each board. Accordingly, the members are not allowed to chair both boards, but executive can attend the supervisory meetings to provide them with the requested details. In general the CEO who heads the executive board usually attends the supervisory meetings, but not as a member (Mallin, 2010, 162; Solomon, 2011, pp.78-79).

In the dual board, shareholders elect the supervisory board’s members while the executive members are appointed by the supervisory board’s members. This type could be effective when there is a good relationship between the chief executive, who heads the executive board and the chairman, who heads the supervisory board (Mallin, 2010, 162; Solomon, 2011, pp.78-79).

Unitary (single-tier) board

It is a one single board, formed by mixing the executive and non-executive directors. Their responsibility covers all company activities. Shareholders elect their members in the annual general meeting, and therefore, all directors have the same ends. Millet-Reye & Zhao (2010) mentioned that in the UK where they have unitary board only, the average number of directors is 8.3, against 19.1 in Germany, where they have the two-tier board only.

The advantages of this type are the closer relationships, better communication and information flow, because all the executives and non-executives are provided with the same information (Mallin, 2010, p162; Solomon, 2011,pp.78-79).

The unitary board is considered effective in solving the potential of agency problems because the non-executive directors have motivation to note their competences to other potential employers, (Fama & Jensen, 1983; Weisbach, 1988 as cited in Conyon & Peck, 1998). Moreover, its non-executive directors are mostly experts in internal control systems and monitoring executive directors.

However, Westphal (1994) claimed that non-executive directors are inefficient in monitoring the top management or influence them, and Finkelstein & Hambrick (1996) clarify that because of the low equity holding and financial incentives. Baysinger & Hoskisson (1990) added that non-executives may hardly be independent if they were members in the company management teams. Westphal & Zajac (1995) justified the ineffectiveness happened when they have a similar viewpoint with the company CEO, and that usually happened in their first period because they will have a similar demographic to the CEO.

Unitary board’s sub-committees

The UK corporate governance code (A.4.1, B.1, C.3, the Code, 2010) demonstrated that the effective board should establish nomination, remuneration and audit committees. The nomination committee is responsible for providing a clear appointment mechanism for board and senior management, and it also gives recommendation for replacement or adding board’s member and their successors. Accordingly, it aims to reduce the CEO or chairman domination and subjectivity in appointment decisions, and prevent the board from a cosy club, so their members are chairmen and independent non-executive directors. Thus, the chairman should not chair the committee when dealing with appointing chairman successor (A.4.1, the Code, 2010; Tricker, 2009)

The remuneration committee role is to form a total remuneration package for executive directors and senior management. This package should be sufficient to attract and motivate their interest to achieve the company goals, and also it should be associated with the long term company outcomes and the individual performance, so the members of this committee should be independent and non-executive directors (B.1, the Code, 2010).

The Audit committee; this committee should be formed from independent and non-executive members, at least one of the members should have “…recent and relevant financial experience…”. It is responsible for forming formal and transparent arrangements for internal control, risk management and company’s reporting, in addition to maintaining appropriate relationships with the company’s auditors (C.3, the Code, 2010). Tricker (2009) mentioned that this committee originated in the USA to prevent audit processes from the domination of senior executives, by building direct communication between the external auditor and the board.

Moreover, there may be other sub-committees available in companies to manage and address detailed aspects to the board, such as risk committee, finance committee, general purpose committee, and executive committee (Solomon, 2011). Particularly the main three committees which are recommended by the Code run significant roles, so their members should be experts, influential, have a high level of ethics, and comply with law and code. Moreover, almost all their members should be non-executive and independent directors. In other words, the Code expects that the non-executives should have high qualifications and their morals are above standards to deliver their roles.

Dahya et al’s study (2008) concluded that the strong board consists of independent directors and leads to better management for companies’ resources. Accordingly, they recommended the strong board for countries that have a weak investor protection because the independent director balances the power of large shareholders.

The development of non-executive directors’ roles

In 1992 the first copy of the Cadbury report was presented, and it was considered the first version of the UK corporate governance code (the Code, 2010). It was released to respond to the Maxwell and Plly Peck scandals. Since releasing the first Cadbury report, the corporate governance has become prominent in the UK, although this report was focused only on the financial side of the corporate governance. However, the first copy of the Cadbury report was followed by several governance reports as such as the Greenbury report in 1995, the Hampel report in 1998, and the Smith and the Higgs reports in 2003. These reports had a wider corporate governance vision, they covered many corporate governance issues as audit committee, remuneration of directors and also underline the roles and the effectiveness of non-executive directors (Du Plessis et al, 2011, p.313).

Du Plessis et al (2011, p.314) mentioned that the first Cadbury report underlined the non-executive directors’ codes because it recommended the wider use of non-executive directors, determined the minimum number of them should be three, underlined their qualifications issue, indicated that the executive remuneration should be subject to a committee wholly formed by non-executive directors, ensured the independence of non-executive directors and suggested the share-option scheme and pensions to accomplish that.

Consequently, Gays (2002) study which ran in 1999 to review the role and effectiveness of non-executive directors, found the highest growth in the participation of the non-executive directors in boards in the UK, and that improvement was attributing to the Cadbury nexus (according to the questionnaires responders) . Moreover, the study indicated that the main duties for non-executive directors were insuring and validating the control system, reviewing and evaluating the risk environment and opportunities, and evaluating the company’s weaknesses and strengths (scholar Gay’s letter to Derek Higgs, 2002).

However, Eilon (1980) claimed that before 2001 there wasn’t serious attention on the mixing board with non-executive directors to confirm the governance mechanism by enforcing the board with their leadership management, specialized experience, monitoring and controlling executive director behaviour, enhancing shareholder confidence, or providing the legal power to the board. Thus, the Enron collapse in 2001 led judiciary to focus attention on the roles and effectiveness of the non-executive directors in board.

The necessary requirement for effective non-executive directors:

However, to acquire non-executive directors’ effectiveness the company’s corporate governance guidelines must indicate clearly their responsibilities, qualifications, competences and remuneration. In this regard, Keenans’ (2004) study stated that there are five points should be adopted and clearly disclosed in company’s corporate governance guidelines. These points are; the qualification and the compensation, their access to management, an orientation and continued education plan…Higgs is very strong on this point…., effective succession plan, and regular board performance evaluation “…Higgs recommends annually…”.

Solomon (2011, pp.82-84) mentioned that the Higgs Reports highlighted the issue of non-executive directors qualifications by emphasizing that their job roles request more than the simple experience they normally attain. Also, they should have high levels of integrity, ethical standards, solve problems, sound judgment, communication skills, and strong personal characters.

The UK Combined Code (2003) grouping the corporate governance to four parts: independence, diligence, professional development, and performance evaluation. For the independence code it mentioned that half of the board, excluding the chairman, should be non-executive and independent directors. The majority of sub-committees should be non-executive and independent. The independence is defined by the Code: a person who doesn’t have material business with the company in the last three years, doesn’t work in a company last five years, doesn’t have significant shareholding, and hasn’t been served by the board for more than nine years (Tricker, 2009, pp.150-151).

For diligence, the code mentioned that non-executives should have enough time to cover their roles so they have to disclose their commitments’, and no member should chair more than one FTSE 100 company. Likewise, for professional development the code mentioned that all directors should have orientation training, and a continuous updating for their knowledge and skills in the company’s business. Consequently, the recent financial crises re-launch the non-executive directors’ roles and qualification as well as remunerations (the Code, 2010). The crises ensure the importance of their experience and competences, the continuous training to improve their qualifications, and the essential increasing of their board commitment times to be able to focus and gain detailed business knowledge.

Finally, the board performance evaluation, the code indicated that the board should have an annual performance evaluation for individual directors and main board committees. Keenans (2004) claimed that it is difficult to achieve a reliable evaluation because it is not easy for non-executive directors to get a good and reliable data base for the reason that the main data resource is the executive directors, and the non-executive directors will evaluate the executive directors’ performance on this basis.

The changed role and expectation of non-executive directors:

According to the Agency theory the non-executive directors’ role is reducing the dispute of interest between shareholders and company management. However, Roberts et al (2005) indicated that the information about the relationship on board and behaviour, according to the stewardship and agency theory, doesn’t reflect the actual experience of non-executive directors adequately. Consequently, the scandals in the beginning of this decade steered the USA to introduce (Sarbanes-Oxley Act, 2002), and the outcome of Derek Higgs report in 2002, which concerned the role and effectiveness of non-executive directors, and led the UK to reform the governance by strengthening the Combined Code on Corporate Governance in 2003. Also, since 2004 the UK Financial Report Council conducted a regular review scheme for the Combined Code on Corporate Governance (Du Plessis et al, (2011, p.315)

The UK corporate governance code (A.4, the Code, 2010) illustrated the roles of non-executive directors as follows: providing a significant contribution in building and developing company’s strategy, examining the company performance, monitoring the top management performance. In addition to this it ensures the reliable and robust financial reports, financial controls and risk management, determining the remuneration levels for executive and senior management besides their crucial role in appointing and removing directors and providing the senior management succession plan.

Moreover, the Code, E, (2010) organized the relationship between the board and shareholders and recommended the board to choose the most effective way to build mutual understanding objectives with shareholders, and also the board is collectively responsible for ensuring that a satisfactory communication takes place.

The research of Long et al (2005) found that the non-executive directors are committed to the UK codes. Thus, there are differences in the priorities between those who chair the listed companies with unlisted, accordingly the factor which encourages or inhibits the non-executive is “… individual’s sensitivity to the cyclical, structural, cultural and procedural dynamics inside and outside the boardroom which ultimately dictates whether original authorship, or sensitive translation, will maximise effectiveness…”.

The conducted survey at Dutch non-executive directors by Hooghiemstra & Manen (2004) indicated that those directors give their priority to monitor senior management, despite that they are doubtful about their achievement for this role effectively. Pettigrew & McNulty (1995) & Keenans (2004) claimed that when non-executive directors monitor and give advice they face disadvantages in relation to executive directors, and almost all are dependent on CEO information to achieve their roles.

Tricker (2009, p. 139) mentioned that non-executive directors have two main roles and they usually face challenges to balance between them; firstly, the performance rules which concern the strategy formulation and policy-making , secondly, the conformance rules which concern executive supervision and accountability. Tricker argued that, due to the limitation in the available time for the board, they almost always concentrate on conformance more than performance. The justification for that is the board expecting that their main role is to ensure corporate governance and compliance with regulations and codes. Conversely, Tricker (2009, p.139) claimed that this unbalancing dangerously affects the principles, rules and regulations of corporate governance and compliance.

Conclusion:

Since 1990 until now a massive development had taken place in corporate governance as well as the non-executive directors’ roles. This development has focused to bring more reliability and effectiveness of the wielding of power over companies globally. However, the first Cadbury report in 1992, which was set up in response to various companies collapse, underlined the importance of independence and non-executive directors in companies. So, it has started to organize their roles and responsibilities to achieve effective corporate governance (Trickers, 2009, pp.1-22).

Consequently, the role of non-executive directors has been reviewed several times by the adjudicators, especially after corporate crises trying to prevent the companies from such collapse, as well as exploiting the effectiveness and control of the behaviour of non-executive directors. Also, they form most or all the board members, to ensure the reliability of governance activities in companies. Therefore, their roles become more complex, covering a lot of duties which sometimes have a conflict in between. As a result these increase the board challenges and responsibilities. Clarke (1998) mentioned that to have an effective board the following functions should run:

“ …strategic performance, approving strategy, checking progress in execution, calling for adjustments and changes, management development and succession ,approving overall approach, checking progress, setting goals for needed change, rewarding and evaluating the CEO ,monitoring legal and ethical conduct, acting as change agents, resulting from monitoring, through counsel and advice, replacing the CEO as last resort, dealing with crisis, gradual crisis - monitoring the position, encouraging change, sudden crisis, Visible events ,Rapid response necessary, …”

The big number and complexity of the board duties, the conflict in between non-executive directors’ roles, the ethical issues, and the limitations in time are all factors which prevent non-executives to achieve their goals and introduce effective boards. However, Clarke (1998) argued that the board could not achieve all his duties unless there are dynamic and effective group processes, high interaction quality between all board members and the executive and non-executive directors.

 

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Raida Mashal

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