It was 1977 - the New York Stock Exchange (NYSE) amended the listing rules making the establishment of an audit committee comprised of outside independent directors a listing condition. The monitoring board, which requires independent directors, formally replaced the advisory board model. The idea was conceived in the aftermath of Penn Central’s (PC) collapse in 1970 - the single largest bankruptcy in the history of the U.S.A., and the detection of illicit payments and frauds by the management of American publicly traded companies. A consensus emerged that the monitoring board was the right choice. Independent directors would objectively monitor the company’s performance and that of the CEO, and the committees constituted of independent directors would focus on issues requiring independent judgment after in-depth analyses of the problems. It was expected that independent directors would perform effectively because of the fear of liability prescribed by law, adequate reward (in the form of compensation) for doing the job well, and fear of losing reputation.
Over the last four decades, the research could not establish conclusively that independent directors improve a firm’s performance. However, researchers could collect evidence that none of the three instruments– liability, reward, and reputation – effectively induced independent directors to perform efficiently and effectively.
Courts do not impose monetary or criminal liability on outside directors unless it is established that the decision-making process was tainted by conflict of interest or that bad faith (intent to deceive). An example is that the outside directors who failed to manage risks and caused the 2008 global financial crisis were not punished. Some experts express the apprehension that imposition of liability might make directors risk-averse, inducing them to put a brake on entrepreneurial initiatives. It might result in the flight of talent. Deciding the right amount and form of directors’ compensation is a vexing issue. Low compensation results in a lack of motivation, and high payment impairs independence. Many experts believe that ESOP and performance bonuses, which companies grant directors to align their and the company’s interests, are perverse incentives, leading to accounting frauds and market manipulations. Directors are not concerned about their reputation because the board’s process is a black box and no outsider ever knows how a director behaves in the board meetings. Reputation is affected only when the company is involved in a financial catastrophe, management fraud, or a major legal problem. Research provides evidence that outside directors resign when they are most required to protect their reputation - when they anticipate that the firm would disclose bad news.
Over the last four decades, regulators have continuously made new rules to make the institution of independent directors effective. For example, SEBI has amended the code of corporate governance introduced in 2002 umpteen times in the last two decades to incorporate emerging global best practices. This clearly shows that the regulators have no faith in independent directors.
It is well established that the CEO is much better informed than part-time outside directors. The information gap is widening in the VUCA world and in an environment where disruption is the norm. As a result, outside directors’ power to monitor the CEO is almost zero. Innovation is the mantra for the survival and growth of the business. An open environment fosters innovation, and a controlled environment impedes the same. The board must give CEO a free hand to encourage entrepreneurship while providing checks and balances. Monitoring the CEO should be relegated to the last in the list of the board’s priorities. The requirement for strong internal constraints on managerial discretion diminishes with the strengthening of the external constraints. Social media widely disseminates information at high speed. This strengthens social and stakeholder activism, forcing managers to behave responsibly.
If we take out monitoring, the board’s other important roles are management (engaging with the CEO in critical management decisions), advisory (advising the CEO) and boundary spanning (managing stakeholder relationships and arranging resources from the external environment through networking). A diversified advisory board with competent outside directors can perform all those functions efficiently and effectively. The independence of outside directors is irrelevant. Globally, the incumbent management and the board appoint management-sympathetic independent directors through networking. Therefore, the question of how independent are independent directors still bothers regulators, investors and other stakeholders.
Regulators seriously debate whether the time has come to revert to the advisory board model rather than modifying rules to improve the institution of independent directors.
Whistleblowing mechanism and improved audit quality discipline the CEO and the board much more effectively than the independent directors.
Independent directors create an illusion that they enforce the CEO’s accountability. In reality, they are in bed with the management.Moneycontrol journalists were not involved in the creation of the article