Introduction
After the corporate scandals of Maxwell, BCCI, Enron, World.Com and others’, corporate governance came into prominence and implemented in national laws. Corporate governance was created with certain reports including various kinds of recommendations. One of the recommendations to hinder corporate failures and control the absolute power of management is to increase the significance of the role of non-executive directors who monitor the management of the company. Management’s power is crucial for corporate governance, because ‘power tends to corrupt, and absolute power corrupts absolutely.’ This recommendation emphasised in several reports in the United Kingdom such as the Cadbury Report 1992 and the Higgs Review 2003 and modern role of non-executive directors became to fore with these reports. Surprisingly, before publishing of the Cadbury Report, the Bank of England evaluated the role of non-executive directors in 1984. This paper will critically evaluate the importance of the role of non-executive directors and its success for preventing corporate scandals.
NON-EXECUTIVE DIRECTORS
Firstly, it is important to examine certain causes of the corporation’s failure for better understanding the role of non-executive directors; hence, The Financial Services Authority has stated brief points on its board report which was published for the failure of the Royal Bank of Scotland. These points are; an ineffective board, a domineering chief executive officer, key posts held by individuals without the required technical competence, inadequate ‘four-eyes’ oversight of risk and an inadequate understanding of the aggregation of risk. Some of the causes on the report are also applicable of the failures of Enron, Maxwell, IPCC and other corporate scandals. In addition to points which were addressed by The Financial Services Authority, the Cadbury Report addressed that non-executive directors are one of the causes for corporate scandals. It is possible to define the non-executive directors' features as part-time, external, and independent. The Cadbury Report 1992 started a deep debate about the effectiveness and responsibilities of non-executive directors because of the failure of Polly Peck, BCCI and Maxwell and after that, the role of non-executive directors was accepted in several reports as a monitoring mechanism for the corporations. This mechanism is a key point here because the board and its actions will be checked by non-executive directors. In other words, mentioned points above were tried to overcome by increasing the significance of the role of non-executive directors. Monitoring the board is the essential point here because the main reason for collapsing of American and British companies such as Enron, World.Com is accounting irregularities, which are manipulated accounting data and showed profits instead of losses. Due to these reasons, the appointment of a non-executive component was important and this is the way to make the accounts’ manipulation difficult by chief executive officers or external auditors. This aim was reflected in the Cadbury Report as ‘non-executive directors should bring an independent judgement to bear on issues of strategy, performance, resources, including key appointments, the standards of conduct’.
One of the other problems is whether non-executive directors are independent or not which means no business or family relationships between non-executive directors and top managers. The Cadbury Report stated that ‘given the importance of their distinctive contribution, non-executive directors should be selected with the same impartiality and care as senior executives’. The problem of 'old boys' club' also known as 'old school tie' was tried to avoid with this recommendation. According to subsequent survey to the Cadbury Report, 70 per cent of non-executive directors were selected by the way of 'old school tie'. The non-executive directors might lose their independence if they are selected by improper way.
The Cadbury Report also emphasised; ‘the Committee believes that the calibre of the non-executive member of the board is of special importance in setting and maintaining standards of corporate governance’. However, this recommendation is not found adequate by the Higgs Review, because the calibre of the non-executive members might be insufficient to avoid corporate scandals such as in the case of Enron, one of the non-executives on the audit committee was a professor of accounting and former dean at Stanford Business School. Even after the Cadbury Report, the corporate scandals could not be stopped and other reports have been published and Sir Adrian Cadbury already stated that the Cadbury report needs to be reviewed in the preface of the Cadbury Report.
The Higgs Review or Review of the Role and Effectiveness of Non-executive Directors was announced by the Department of Trade and Industry in 2003. Non-executive directors are described on the Higgs Review as ‘a non-executive director is considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect the director’s judgment.’ According to Higgs Review, the role of non-executive director's is as follows:
Strategy: Non-executive directors should constructively challenge and contribute to the development of strategy.
Performance: Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance.
Risk: Non-executive directors should satisfy themselves that financial information is accurate and that financial controls and systems of risk management are robust and defensible.
People: Non-executive directors are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, senior management and in succession planning.
The Higgs Review recommended that one of the non-executive directors needs to be appointed as a senior independent director and a senior independent director should attend the meeting with several times. The main idea of the senior independent director is to make a connection between shareholders and the board and it is a significant role in the corporate body because shareholders sometimes have a difficulty in reaching the board, moreover this is the one important reason of the failure of Maxwell and Poly Peck.
The Higgs Review recommends that the board need to consist of the majority, at least one-third, independent non-executive directors. The Cadbury Report had suggested that 'the board should establish an audit committee of at least three non-executive directors'. All these recommendations serve to monitor the board.
The UK Corporate Governance Code 2014 is based on reports and has similar recommendations with all reports such as the Cadbury Report and Higgs Review. It should not be forgotten that the UK Corporate Governance Code’s form is also a code and not legally binding. Finally, there is no distinction between executive and non-executive directors in the Companies Act 2006, it means the UK courts apply equally the same duties for both executive and non-executive directors. On the contrary, there is a strict distinction between non-executive directors’ and management’s duties in Germany that is a good example of corporate governance.
Conclusion
Undeniably, all these attempts are very beneficial for corporate governance’s main aim which is to prevent corporate failures. However, the main problem with these codes include recommendations for non-executive directors are an example of soft law, in other words, these attempts are only a code and compliance with it is voluntary. These attempts need to be a hard law for the best corporate governance and to hinder corporate scandals in the future. Making code, which is not legally binding, is likely a muted response after the corporate failures. The best example of the effectiveness of these codes, after a year that Higgs released, nine former non-executive directors of Equitable Life are sued for negligence and breach of their fiduciary duty in failing to take legal advice. Another point is that board should reach decisions by the power of argument not by immediate resort to voting on issues, where the simple power of number would count. It being said that; to increase the number of non-executive directors may not be sufficient to reach a good decision for the corporation. Last but not least, separation of the duties in the Companies Act 2006 would be beneficial because it is clear that non-executive directors’ duties are different in the respect of executive director’s duties. Making the duties clear in the Companies Act 2006 will increase the significance of non-executive directors like Germany. Dimension of the auditors, the increasement of legal responsibility of auditors might serve to avoid corporate failures. Lastly, it should not be forgotten that, beyond all these solutions, non-executive directors ‘need to have intellect, integrity and courage. Of these qualities, courage is the most important, for without it the other two characteristics are useless’.