Name: Brian Lee Shun Rong (G14)

Discuss the effectiveness of independent directors in producing good

corporate governance.

Independent directors are perceived by the corporate world as one of the most
effective solutions to corporate governance problems. In many countries, the
Companies Act, a set of regulations that all registered companies in the
relevant country have to comply with, requires listed companies Audit
Committees to be either mostly or completely comprised of independent
directors, on the basis that they will exercise unbiased judgement when
carrying out their duties. However, although independent directors are in
theory, effective for producing good corporate governance, extensive research
has proved that in practice, their effectiveness is limited. This paper seeks to
prove this argument.

According to NASDAQ, an independent director is a person other than an

executive officer or employee of the company or any other individual having a
relationship which, in the opinion of the issuer's Board of Directors would
interfere with the exercise of independent judgment in carrying out the
responsibilities of a director. There are two main rationale for companies
employing independent directors to the Board. Firstly, independent directors
are perceived as being able to contribute to better corporate performance.
Independent directors can help offer management an alternative and neutral

viewpoint when faced with important business decisions. Often, companies

appoint independent directors with vast amount of experience and expertise
in fields which are of relevance to the company, and with this experience and
skills, they will be able to offer strategic business advice to companies.
Secondly, independent directors are viewed as being able to promote good
corporate governance, which generically refers to guarding against financial
manipulation or corporate fraud, and encouraging more transparent corporate
reporting. Companies believe that independent directors, having no
motivations to manipulate financial results, will serve as whistle-blowers to
monitor the actions of management, discovering and preventing wrongdoing
which can be detrimental to the company, such as financial results
manipulation or fraud. This is especially important in the case of public
companies, where companies have a duty to their shareholders to ensure that
management always acts in the best interest of shareholders. For years, it has
become conventional wisdom that well-managed companies should have a
significant presence of independent directors on the Board. Hence many public
company boards consist of a sizeable number of independent directors, not
just because regulations require them to adopt this practice, but also largely
because independent directors help increase the value of the firm to
shareholders.

However, empirical research does not support the theory of independent

directors. Years of extensive research and detailed studies have produced no

clear evidence of a positive correlation between board independence and

corporate performance, for some studies have shown positive correlations
while others show no or negative correlations. Studies have not shown that
heavy majorities of independent directors are superior at monitoring
companies either. Furthermore, recent cases of financial fraud such as Enron
and Worldcom have not been able to be prevented by a supermajority of
independent directors in their company boards. The head of Enrons audit
committee, Robert Jaedicke, was an accounting professor at Stanford
University and thus highly qualified for the job but still failed to detect the
sophisicated fraud by company insiders.

There are a number of reasons as to why the reality differs so significantly

from the theory. First, independent directors may not have any motivation to
distort financial statements, but that does not mean that they have sufficient
incentives to prevent fraud or manipulation. It may be argued that their
reputational concerns, and the fact that they are liable for issuance of false or
manipulated financial reports is enough incentive for it to be in their interest
to prevent such incidents. However, in fraud cases, a dishonest management
will take every effort to conceal evidence from the independent directors, and
usually succeed in doing so since independent directors generally lack
information about what is really going on in a company, as they are not
involved in its direct management. Therefore, uncovering fraud cases is not
impossible, but this would mean that independent directors would have to put

in a lot more effort than company insiders to get the information essential for
the prevention of the fraud. However, most independent directors have
multiple means of employment, often sitting on multiple company boards and
thus have insufficient time to put in the extra effort to gather the information
required. The limited time they can allocate towards one company would
mean that they would monitor the company mainly based on the information
given to them by the management, which might not reflect the full picture. For
example, ever since the introduction of the Sarbanes-Oxley Act in the USA,
which made more stringent monitoring mandatory, the time needed for Audit
Committee meetings has more than doubled. Due to their multiple
commitments, there is now insufficient time for many directors to complete
their work, and their discussions often end up being truncated or spilling over
into hastily arranged teleconferences."1 This adversely affects the
effectiveness of their monitoring. In addition, independent directors can
escape liability by claiming ignorance of the fradulent actions of management
which had been concealed from them, so this reduces the incentive for them
to prevent corporate wrongdoing.

In addition, research has shown that reputational concerns can actually be

more of a hindrance than a help to independent directors monitoring duties. A
2010 study by Fahlen, Low and Stulz has found that outside directors are more
1

Jay W. Lorsch & Robert C. Clark, Leadingfrom the Boardroom, 86 HARV. Bus. REV. 104, 107 (2008).
However, some scholars indicated that directors have been serving on fewer and fewer boards since SOX,
and that would help boards maintain a performance advantage. See Robert A.
Prentice & David B. Spence, Sarbanes-Oxley as Quack Corporate Governance: How Wise is the Received
Wisdom?, 95 Geo. L.J. 1843, 1865 (2007).

likely to resign from boards when they find that the company is in trouble, to
preserve their reputations.2 Thus rather than perhaps working to prevent a
fraud that they suspect is happening, they would rather leave if they find that
it is difficult to gather evidence to prevent the incident from happening and
their reputations going down the drain with the company.

Second, the current definition of independence specified by company

regulatory bodies does not cover all the potential influences which might
affect the directors unbiased judgement pertaining to matters of the
company. Currently the definition specifies that independent directors must
not have any business ties with the company and its management, but
overlooks personal relationships. The key problem is the need or inclination for
the independent director to maintain good grace with the management, thus
potentially influencing the effectiveness of the directors monitoring duties.
Friendships between the director and members of the management will
undermine the neutrality of the directors judgement, as when faced with
difficult decisions such as exposing the fraud of a manager, the inclination to
maintain friendly ties might affect the directors decision. While regulatory
requirements may be expanded to cover friendships, it would still fail to
capture friendships that develop between the independent director and
management during the course of his time at the company. Therefore it is very

Fahlenbrach, Rudiger, Low, Angie and Rene M. Stulz, 2010, The Dark Side of Outside Directors: Do They
Quit When They are Most Needed? ECGI - Finance Working Paper No. 281/2010. Available at SSRN:
http://ssrn.com/abstract=1585192

difficult for authorities to ensure that independent directors are indeed truly
independent, and thus would completely and impartially fulfill their duties.

Finally, the appointment of independent directors poses a key problem to

corporate governance. This is because the director may be inclined to conform
to the interest of the manager who appointed him. In the USA, the
appointment process is greatly influenced by management, and often
management would invite favoured candidates for independent director
positions who might be friends of management, thus undermining their
independence. Some regulators have recognized this problem and thus require
that independent directors be appointed by an independent nomination
committee. However, the same problem still applies since the members of the
nomination committee are usually appointed by shareholders, and since
management are in many cases, major shareholders, they tend to have
powerful voting rights and thus great influence over who gets nominated. A
relevant example is the Sweden Corporate Governance Code, which dictates
that independent directors be nominated by a nomination committee
comprising of at least one independent member. However this committee is
nominated by shareholders at the Annual General Meeting, where major
shareholders can determine the members through their powerful voting rights.
Therefore the current appointment process is such that it can be heavily
influenced by management as there are no restrictions on the amount of

company shares they can own, and they might not necessarily act in the best
interests of shareholders, undermining corporate governance.

The reasons given account for the discrepancy between the theory and reality
of the effectiveness of independent directors. It thus disproves the popular
belief, supported only by theory, that independent directors produce good
corporate governance. Therefore it shows that companies cannot rely merely
on a majority of independent directors in their boards, and have to seek other
solutions to ensure effective corporate governance.

References:

Wallison, P.J. (2006). All the Rage: Will Independent Directors Produce
Good Corporate Governance?
AEI Online. Retrieved from
http://www.aei.org/article/economics/financial-services/all-the-rage-willindependent-directors-produce-good-corporate-governance/

Chou, C.F. (2013). Are Independent Directors Effective Monitors in

Taiwan- A Theoretical Analysis National Taiwan University Law Review.
Retrieved from

http://www.law.ntu.edu.tw/ntulawreview/articles/8-1/2-Articile-ChengFong%20Chou_49-95_.pdf

Gutierrez, M., & Saez, M. (2012). Deconstructing Independent

Directors. European Corporate Governance Institute (ECGI)- Law
Working Paper No. 186/2012. Retrieved from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1986842