The Concept of Board Independence
Introduction
According to Agrawal & Knoeber (2001), the concept of independent director is a vital subject within the broad concept of corporate governance. As Corporate Social Responsibility is increasingly becoming a prominent subject, corporate boards of directors are also becoming more engaged in shaping and evaluating the policies and practices of companies on various environmental and social topics. The general CSR performance of companies has come under scrutiny. According to Almazan & Suarez (2003), a parallel movement of good governance has put composition, structure and behavior of corporate boards under tight scrutiny. Stakeholders and shareholder activists have cited the need of corporate directors to be more independent of the management and more active. Stakeholders have also demanded that corporate governance to accurately reflect a wide of constituents. Despite corporate governance receiving significant deal of media attention, the concept is comparatively new. Baker & Gompers (2003) defined corporate governance as a system by which companies are controlled and directed. The system of corporate governance specifies distribution of responsibilities and rights among managers and shareholders. It also specifies the procedures and rules for making decisions concerning corporate affairs. Nevertheless, corporate governance also incorporates the relationships with a wider range of stakeholders. In this regard, Bebchuk & Cohen (2005) defined corporate governance as the design of an institution or a company that forces or induces the management to internalize the stakeholders’ welfare. Corporate governance has the problem of independence, especially in relation to board members. In this regard, this section offers a review of the previous and present literatures concerning the board independence.
The Role of Board of Directors in Corporate Governance
The public frequently questions whether boards of directors are important since their daily effects are difficult to observe. Nevertheless, boards of directors are usually the center of attention whenever things go wrong within the corporate governance. Since every corporation has a board of directors, the question of whether these boards play a vital role cannot be answered econometrically. According to Boone et al. (2007), this is because there is difference in the explanatory variable. Instead, researches examine the variations in the manner in which companies function. Unfortunately, it is extremely difficult to observe the variations. For example, a population assumption is that non-management directors behave differently than management or inside directors.
The major conclusions of Brick, Palmon & Wald (2006) and Brown (2007) were that the corporate boards act as a source of counsel and advice. They also act as some kind of discipline in times of crisis. For instance, if there is need to change the Chief Executive Officer (CEO). However, according to Carter, Simkins & Simpson (2003), the nature of counsel provided by the board of directors is unclear. Choi, Park & Yoo (2007) suggested that the board of directors acts largely as a sounding board for the top management and the CEO by intermittently offering expertise when the company faces an issue concerning which one or more board members are expert.
However, Conyon & Read’s (2006) survey showed that about two thirds of board of directors agreed that establishing the strategic direction of the company was of the major responsibilities they are assigned. About 80 percent of the board of directors also agreed that they were engaged in the establishing of the company strategy. About 75 per cent of respondents of Dahya, McConnell & Travlos (2002) study also reported that they were engaged in the setting of the company strategy, corporate policies and overall mission, direction and mission of the company.
Various studies have agreed that the disciplinary responsibility of board of directors is unclear from descriptive studies. Deli & Gillan (2000) suggested discipline considerably stems from the top management and the CEO. However, the CEO and other individuals comprising the top management must before the board, which is made up of their peers. Xie, Davidson III & DaDalt (2003) and Song & Thakor (2006) took a dimmer perspective by arguing that corporate boards are so passive that they rarely engage in disciplinary responsibilities. Ryan & Wiggins’s (2004) statistics are broadly in line with this dimmer view. This is because less than half of the respondents agreed that their job was to monitor the top management.
The Concept of Board Independence
The concept of board independence is visible in various points of corporate governance. Board independence is listed as of the crucial underpinnings of corporate governance. According to Palia (2001) and Naveen (2006), board independence is a critical quality possessed by both the external and internal auditors. Therefore, independence is vital in various contexts of corporate independence. According to Linck, Netter & Yang (2008), it is important for external auditors to be independent of their clients, for internal auditors to be independent of the colleagues they are auditing, for non-executive to have a level of independence from their executive colleagues on board. The most important question is: what is independence a concept of corporate governance. Laux (2008) defined ‘independence’ as a quality, possessed by people and is a required component of professional behavior and professionalism. According to Kumar & Sivaramakrishnan (2008) and Klausner, Black & Cheffins (2005), independence refers to the avoidance being overly influenced by a vested interest. Ferris, Jagannathan & Pritchard (2003) also defined independence as being free from any restrictions, which would inhibit would the required course of action being performed. Therefore, board independence refers to the capacity of the board to stand apart from the inappropriate influences, and to be free capable of making the uncontaminated and correct decision on a certain issue.
For example, if an auditor is an old friend of a client being audited, he or she might not be adequately independent of the client (Egwuonwu 2010). Since it is the job of the auditor to serve on behalf of the shareholders and not his client, the friendship between the client and the auditor might interfere with the ability of the auditor to efficiently represent the shareholders’ interests. As such, the auditor might be as comprehensive as he should be. This is because he might be influenced to provide the benefit of doubt to his client when he is not support to do so. This scenario can also apply to the non-executive directors (NEDs) (Deli & Gillan 2000). Shareholders appoint non-executive directors in order to represent their interests on company boards. According to Brown (2007), the major fiduciary obligation of the non-executive directors is owed to the shareholders of the company. As such, Brick, Palmon & Wald (2006) pointed out that this implies that they should allow themselves to be unduly influenced or captured by the vested interests of other company members such as trade unions, executive directors or the middle management.
Degree of Independence
A popular problem in various organizational scenarios is guaranteeing independence where is ought to represent an ethical threat if absent (Brown 2007). Networks and friendships in real-life build over a long time in which relationships exist at a various levels of intensity. Audit engagement partners can get to know clients over many years. For instance, non-executive and executive members of a board, serving together on the same board, can cement friendships between them. Apparently Bebchuk & Cohen (2005) set out to determine the various levels of board independence. In his study, they found out that the use of continua was significant in describing variables of independence. A continuum refers to a speculative construct that describes range and extremes of possible states. In the case of a continuum, there are two levels of independence: total independence and zero independence. In total independence, the parties in the relationship have no connection with each other. According to Carter, Simkins & Simpson (2003), the parties might not know the identity of each other. Therefore, the parties do not have a reason to act dependently. On the other hand, the there is a zero independence level. In this level of independence, the parties seem to be intimate with each other. As such, Choi, Park & Yoo’s (2007) study revealed that parties in this level of independence cannot make decisions without considering the impact of their decision on the other parties concerned.
Independence and Non-executive Directors
As mentioned above, the fiduciary responsibility of non-executive directors is owed to the shareholders of the company. Studies conducted by Song & Thakor (2006) indicated that some company shareholders prefer bringing new non-executive directors from another industry in order to increase the independence of non-executive directors. According to Carter, Simkins & Simpson (2003), this is because various independence-threatening casual networks can build up in an industry over the years as employees move between competitor companies, and as they collaborate in industry umbrella.
There is an argument concerning the pros and cons of choosing non-executive directors having some industry experience compared to choosing non-executive from another industry in which the company does not compete. According to scholars such as Choi, Park & Yoo (2007), previous industry participation results in higher technical knowledge of problems and issues in that industry. In concurrence with Palia (2001), Brown (2007) asserts that it brings with a network of contacts and the awareness of the strategic issues within the industry. As much as this might be of great benefit, Brown (2007) and Palia (2001), pointed out that previous industry involvement might also reduce the ability of executives to be uncontaminated and objective by the previously held views. In other words, according to Palia (2001) and Choi, Park & Yoo (2007),, they can make the non-executive less independent.
Most previous studies concerning corporate governance have recommended that it is vital to increase the proportion of independent directors on the board. The huge majority of previous studies have argued for this recommendation from an agency theory perspective. According to agency theorists, the major function of the boards of directors is to monitor the managers’ actions on behalf of the shareholders. In agreement with the theorists of agency, Linck, Netter & Yang (2008) and Bebchuk & Cohen (2005) defined board independence as the degree to which the members of the board are dependent on the present organization or CEO. As such, they consider board independence as a primary to the efficiency of monitoring of the board. Brown’s (2007) finding revealed that boards comprising primarily of insiders, who are former or present employees or managers of the company, dependent outside directors, who are directors having business relationships with the company, are viewed to be less effective. The study concluded that this is because of the independence of such directors on the company. Studies of Bebchuk & Cohen (2005) found out that independent boards are primarily comprised of independent outside directors. This study concluded the effectiveness of such boards is because the incentives of the directors are not interfered with the dependence on the organization or CEO. Despite some experimental support has been revealed for this proposition associating independent boards with firm performance, other studies do not support this hypothesis.
An unconventional perspective would suggest that inside directors have better and more information that allows them to assess managers more efficiently. According to Almazan & Suarez (2003), this approach agrees with the resource dependence theory. According to resource dependence theorists, such as Baker & Gompers (2003), a firm is an open system that is dependent on the environmental contingencies and external organizations. Resource dependence theorists perceive corporate boards as providers of resource. As resource providers, Baker & Gompers (2003) pointed out that corporate boards provide four types of resources that include legitimacy, advice and counsel, preferential access to support or commitments from important elements outside the company, and channels for conveying information between external organizations and the company.
By associating the company with the external resources and environment assists in reducing the external dependency. According to Baker & Gompers (2003), this also assists in diminishing the uncertainty of the environment, and lowers the transaction costs. According to Almazan & Suarez (2003), both outside and inside directors might bring important resources and linkages to the board. Nevertheless, directors having ties with the present organizations will be more motivated to provide resources. Regardless of the empirical support for this proposition, a meta-analysis for about 50 studies indicated that there is no statistically substantial association between the financial performance of a firm and the dependence of the board.
The Impact of Board Independence on Company Performance
Almazan & Suarez (2003) recently surveyed the literature on how the composition of the board affects performance of the company. Previous studies concerning the impact of board composition on company performance usually adopt any of the two approaches. The first approach involves assessing how board composition influences the behavior of the board on discrete tasks, like replacing the Chief Executive Officer, making or defending against takeover bid, or awarding golden parachutes. According to Almazan & Suarez (2003), this approach might incorporate tractable data that makes it easier for researchers in order to find statistically significant results. However, according to Boone et al. (2007), it does not show how board composition influences board performance. For instance, there is confirmation that companies with majority sovereign boards perform perfectly on certain tasks, like replacing the CEO and making taking over bids. However, these companies perform worse on other tasks that cannot readily be assessed using this approach (Boone et al. 2007). Firms with majority independent boards perform badly in tasks such as choosing new strategic decision or appointing new CEO for the companies. This results in to no advantage in the overall performance of the company.
Previous studies do not establish an apparent association between board independence and the performance of the firm. Early studies by Agrawal & Knoeber (2001) indicated a positive association between the number of performance measures and insider directors. Agrawal & Knoeber (2001) also reported no substantial relationship between the composition of a board and the various corporate performance measures. Agrawal & Knoeber (2001) reported that the percentage of independent directors in 1970 associates with the return on equity of 1980.
Three recent researches provide clues that companies with high proportion of independent directors might perform worse. Song & Thakor (2006) reported a considerable negative association between performance and the proportion of independent directors. However, the study did not reveal any considerable association between board directors and several other variables of performance, such as sales, operating income and operating income. Xie, Davidson III & DaDalt (2003) also reported a negative association between performance and the percentage of outside directors. Song & Thakor (2006) reported a considerable negative association between the percentage of independent directors and a measure of change in a market value of equity. However, they reported no significant results for raw stock market returns and return on assets.
Naveen (2006) revealed that the prices of stock increase by about 0.2 per cent averagely, when firm appoint extra outside directors. According to Boone et al. (2007), this increase, though vital statistically, is economically small and might reflect signaling impacts. The appointment of additional independent director might show that a firm plans to deal with its business problems, even if the board of directors does not affect the ability of the company to deal with these problems. Boone et al. (2007) revealed that the prices of stock neither decrease nor increase on average when additional directors are added to the board.
According to Boone et al. (2007), the representation of inside director on the investment committee of the board associated with the increased performance of the firm. They find out that there is little proof that monitoring committees, which are generally dominated by independent directors, affect the performance of the company irrespective of how they are staffed.
Various researchers, including Boone et al. (2007), have assessed whether the composition of the board affects the performance of the company. Bebchuk & Cohen (2005) reported that the proportion of independent directors on large corporate boards increases slightly when the firm performed poorly. According to their study, companies in deciles of the performance in year X increases their proportion of independent variable by about 1 percent. On the contrary, Boone et al. (2007) revealed that there is no tendency for companies in the bottom quintile for 1991 stock price returns to add more independent directors in 1992 and 1993 than firms in the top quintile. Bebchuk & Cohen (2005) reported that companies that considerably increase their percentage of independent directors had stock price that was above average in the previous year. Studies of Bebchuk & Cohen (2005) also reported that average composition for group of companies changes slowly over time, and that the composition of corporate board seems to regress the mean.
Conclusions and Recommendations
For companies to improve the independence of corporate executives, various provisions are made in company policies and in codes of corporate governance. The nature of such provisions and their enforceability in law also varies with the jurisdiction. First, it is frequently the case that non-executive directors should have financial, business or other connections with the firm during the previous few years. For instance, this implies that the non-executive director should not have been a shareholder, an employee, a supplier, an employee or a considerable customer to the company. The second recommendation is that cross-directorship should be banned. Cross-directorship occurs when a director of Firm X acts as non-executive director in Firm Y and, at the same time, an executive director of Firm Y acts as a non-executive director at Firm X. Studies have considered such relationships to cause two corporate boards to be intimately involved with each other. This potentially decreases the quality of scrutiny that the two non-executive directors involved in the cross-directorship can bring. The third recommendation is total bans or restriction on share alternatives for non-executive directors. Such total bans and restrictions are intended to guarantee that non-executive directors are capable of standing slightly apart from the executive board, and provide scrutiny and advice that are unconstrained by the vested interest, like short-termism on the share price of the company. Non-executive contracts sometimes enable them look for confidential external legal advice on matters on which they are not happy, certain or comfortable. This needs to be the expense of the company, and assists the director in gaining outside and objective advice on the issues they are concerned about. Lastly, the appointment of non-executive executive is usually limited in terms of time and the number of terms they can serve. In conclusion, board independence is a necessary quality in various situations in both professional behavior and corporate governance. Board independence is sometimes increased and underpinned by legislations. However, it is expected of each professional person and each professional accountant.
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