Essay: Role of independent directors in corporate governance

Corporate governance is not just a compilation of norms and procedures, it is the way in which companies conduct business. Further, it ingrains the principles of transparency, ethics and accountability into the day-to-day operations. This would have a positive effect on the company’s employee and customer value propositions.
Several Indian companies have high quality boards and have implemented governance practices that are way beyond the stipulated regulations. It is important to reflect on how promoters have gained from adopting such practices. Promoters who have gone the extra mile by having independent directors with diverse profiles on their boards argue that the adoption of an inclusive approach to governance that takes cognizance of the needs of employees, shareholders, customers and communities results in organizations becoming better in their businesses over the longer term. But to derive this benefit, it is important to clarify what is expected of independent directors on the board. It is also equally important to set the right tone at the top in terms of ethical leadership of the board.
Concept of Independent Directors
The concept of the institution of independent directors (ID) is simple. They are expected to be independent from the management and act as the trustees of shareholders. This implies that they are obligated to be fully aware of and question the conduct of organizations on relevant issues. After the break out of some of the largest corporate scams in the country in recent times and the subsequent increase in the number of resignations by IDs, there is a heightened focus on their role and responsibilities as custodians of stakeholders’ interests.
The appointment and functioning of IDs is the part of a larger scheme to bring about more accountability into the working of organizations. The fundamental purpose for the appointment of IDs is to ensure impartiality. However, in many organizations, the criteria for selecting IDs continues to be adhoc and individuals typically known to the promoters are often appointed as IDs on board to ensure minimum interference by them. A new trend is the practice of having celebrities on boards to add the glamour quotient to organizations. However, such directors may not know much about the business.
Globally, with the evolving regulatory landscape, which makes them responsible for the prevention and detection of fraud, directors have begun exercising adequate oversight on the management of the risk of fraud. Non-compliance with these regulations or guidelines can have serious repercussions for directors, including their reputational loss and personal liabilities.
The IDs can play the crucial role of bringing objectivity to the decisions made by the board of directors by playing a supervisory role. While they need not take part in the company’s day-to-day affairs or decision making, they should ask the right questions at the right time regarding the board’s decisions. Raising the appropriate red flags at the right time would help them in avoiding the occurrence of unwanted situations and their consequences to a great extent.
10 questions every director should ask:
1. Do we set and communicate the right “tone at the top”?
2. Do we effectively assess our corruption risk?
3. Do we have effective standards, policies and processes to address these risks?
4. Do we adequately communicate and train directors on our anti-bribery and corruption policies and processes?
5. How do we know that our training is effective?
6. What incentives do we provide for compliance and penalties for noncompliance?
7. How do we monitor and audit to detect improper conduct?
8. Do our compliance officers have adequate clout, resources and independence?
9. How do we review the effectiveness of our compliance program?
10. When we find a problem, do we ensure that an independent and thorough investigation is carried out?
Case of Lehman Brothers
Lehman Brothers started in 1844 as a small grocery and dry goods store established by Henry Lehman. Two decades later they traded cotton, moved to New York and established New York Cotton Exchange. After this events Lehman continued on the road of success and became the fourth-largest American investment bank. They survived the World wars and the Great Depression, however, the collapse on the U.S. housing market brought Lehman Brothers to its knees.
Objectively, there are many reasons why Lehman Brothers failed, but we could divide them to two main groups – technical issues and corporate governance failures. Lehman Brothers had very weak corporate governance arrangements, no wonder when the turnover chief expressed his opinion towards corporate governance as follows: “Corporate governance is a joke”. The main areas of weakness were board of directors, corporate risk management, remuneration scheme and nomination committees.
According to the OECD principles, the corporate governance should “ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders”. Based on these principles, board members supposed to act on a fully informed basis, in best interest and fairly to the company and shareholders. They should apply high ethical standards and should be able to exercise objective independent judgment on corporate affairs. Moreover, they supposed to fulfill several functions including reviewing and guiding corporate strategy, risk policy budgets and business plans. Board should also monitor the effectiveness and manage potential conflicts of interest as well as oversee the process of disclosure.
Lehman Brothers Board of Directors was composed of ten members. The Chairman and CEO was Richard S. Fuld, Jr. and included eight independent directors according to NYSE. However, behind all of that there was a fact, that nine out of 10 directors were retired. Moreover, their average age were 68.4 years (four of them were over 75 years), only two of them have direct experience in financial service industry and only one of them had current financial sector knowledge. In addition, one was U.S. Navy officer, another theatrical producer. Pointless is also the fact, that indeed board members should be independent and suppose to take care of the corporation, they cannot do it very precisely. Especially not, when they are for instance director of Weight Watchers International, as well as chairman of Lehman’s governance and nominating committee and a member of the compensation, finance and risk committee at the same time (e.g. Marsha Johnsons Evans). At the end of this section, we also cannot forget to mention, that Lehman Brothers board members were paid for their services extremely well, since the range was from $325 000 to $397 000 plus very high every year bonuses. However, this hasn’t been enough to Mr. Fuld who rewarded his self with nearly half a billion dollars between 1993 and 2007.
Since Lehman Brothers were a leading investment bank, it was inherent that risk is a part of their day-to-day business. Financial markets are, by the principles, uncertain and face variety of risks – credit market, liquidity, legal, reputation and operational risk. Therefore, good risk management is considered to be a base of all operations in the company, as well as risks should be appropriately measured and analyzed.
In Lehman Brothers, overall risk limits and risk management policies were established by the company’s Executive Committee. Apart from that, the Risk Committee (which consisted of the company’s Executive Committee, the CRO and CFO) should meets weekly to discuss all potential threats and risk taking activities. Sad is, that these facts are only pure statements in Lehman Brothers policy manual of quantitative risk management. In reality, this committee met only twice in the year 2006 and 2007. Besides that, Lehman started high- risk business years before its bankruptcy. It was a period of aggressive growth strategy to overcome their problems. During this period they developed exposures to risky subprime lending, structured products, commercial real estate and high-risk lending for leveraged buyouts, but they have not considered enough that these loans were less liquid that its usual investments and had more vague prospects. Further, according to the Valukas report, they exceeded internal risk limits and controls to pursuit higher earnings, what was the start of the end.
Valukas report further stipulates that there is evidence that top officers of Lehman Brothers Company violated their duties by exposing the company to potential liability by filling misleading reports and financial statements.
There are several problems.
First of all, Lehman Brothers had very weak corporate governance arrangements and officers were not forced to fulfill the principles. Good instance is a situation in their board of directors.
Secondly, the most important issue is why companies should abide the OECD principles, if there are no consequences of breaking them. I think that until the corporate governance framework will not be under the law, these cases will arise.
From nature, people are very inventive and they always look for means how to increase their personal wealth. There will always be a group of people which goes beyond the principles as far as the law permits and who will look for the opportunities to overpass the law. To conclude, I would see the key issue in setting the system in the way, in which it will minimize opportunities of these speculators and therefore minimize the failures of corporate governance.