This article has been written by Jitendra Mathur pursuing an Executive Certificate Course in Corporate Governance for Directors and CXOs from Skill Arbitrage.

This article has been edited and published by Shashwat Kaushik.

Introduction

Corporate governance has become increasingly important in recent years, as investors and stakeholders alike demand greater transparency and accountability from businesses. One of the key components of corporate governance is the board of directors, which is responsible for overseeing the company’s management and ensuring that it is acting in the best interests of the shareholders. Independent directors play a vital role in this process, as they are not affiliated with the company’s management and are therefore able to provide an objective perspective on the company’s affairs.

This paper will explore the effectiveness of an independent director on any board. It will describe the aspects in which an independent director would be functioning in order to discharge one’s duty as an independent board member as expected by the role.

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Independent directors play a vital role in corporate governance by providing an objective perspective on the company’s affairs and by holding management accountable for their actions. To be effective, independent directors must be truly independent, possess the necessary expertise and experience, and be objective and analytical in their approach to their duties. They must also be able to communicate effectively with management, fellow board members, and shareholders, and to collaborate with others to develop effective governance practices.

Who is an independent director

An independent director is a name given to a board member who is not related to the promoters or employees of a company in any way. They are also known as outside directors and carry the responsibility of striking a balance between the interests of promoters and other stakeholders, especially small investors. This, in turn, means they happen to be playing the role of a watchdog.

The independent directors bring unbiased and new perspectives to run the business or organisation based on their varied experience from different organisations, expertise in their field or both.

An independent director is a member of the board of a company who has no direct or indirect relationship with the company or its promoters and is not involved in active day to day management. Independent directors are an important link between a company’s board and other stakeholders. The presence of independent director on board is to ensure that the interest of stakeholders are protected, especially the non-controlling ones.

Independent directors do not have any conflict of interest with the company as well.

Roles and responsibilities of independent director

Independent directors are responsible for improving the company’s corporate credibility and governance standards, play an important role in managing associated and perceived risks, and also be part of and actively participate in different committees, setup by the company to ensure good governance

The key role of independent directors is to ensure corporate governance:

  • To uphold ethical standards of integrity and honesty,
  • Act objectively while exercising fiduciary duties during deliberations on board
  • Bring new perspectives and provide technical expertise on issues of strategy, risk management, and performance evaluation of board itself. 
  • Succession planning of top management
  • Plan remuneration of top management and managers
  • Balancing the stakeholders’ interest and management’s interest
  • Safeguard the interest of all stakeholders
  • Monitor system to ensure financial integrity and all types of business risks
  • Report unethical practices, fraud and violations of government and company policies
  • Resolve conflicts
  • Audit and internal control
  • Effective supervision of regulations
  • Sustainable development of the company and it’s stakeholders

Board composition

The board of directors is the governing body of a company. It is responsible for overseeing the management of the company and ensuring that it is run in the best interests of the shareholders. The board consists of several members, each of whom has specific roles and responsibilities.

The executive members of the board are responsible for supervising the day-to-day management of the company. They typically include the CEO, CFO, and other senior executives. The chairperson of the board is responsible for leading the board meetings and ensuring that they are conducted in a fair and orderly manner. The independent directors are not employed by the company and are not affiliated with any of the executive members. They are responsible for providing objective oversight of the management and ensuring that the company is run in the best interests of the shareholders.

At least one-third of the members of the board should be independent directors. This is to ensure that the board has a diverse range of perspectives and that the independent directors can provide objective oversight of the management. The independent directors are typically elected by the shareholders and serve on the board for a specified term. They are not eligible to vote on matters that involve their own personal interests.

The board of directors is an important part of a company’s governance structure. It is responsible for ensuring that the company is run in a responsible and ethical manner and that the interests of the shareholders are protected.

Assessment defined

Assessment process basically comprises of data collection, data analysis and its interpretation to arrive at a conclusion for learning, development and continuous improvement. It is very important to be clear that interpretation should lead to actions which will improve the operations, which here means corporate governance.

So, the assessment requires:

  • Clarifying the role expectations in objective terms with independent director.
  • Setting up clear measurements that lead to the desired behaviours by independent director/s.
  • Self assessment and assessment by board members as per the rules and regulations applicable, as well as improving it.
  • Drawing actions to achieve the expectations of independent director.
  • Also, independent directors are supposed to evaluate the effectiveness of board managing day-to-day activities and senior management.

Challenges for independent directors

  • If remuneration is too high, the independent directors may tilt towards decisions taken by non-independent directors.
  • If remuneration is too low, the independent directors may not have enough motivation to effectively monitor the decisions and processes during board meetings.
  • Another interesting aspect is the position of the independent director in the board hierarchy. New/ lower position may hamper the intervention itself, by IDs.
  • The information flow to IDs may also be limited for those outsiders, especially if the board chairperson and CEO are the same person. This may hamper effective monitoring.
  • Maintaining high ethics.
  • Limited areas of expertise and depth of knowledge.
  • Tokenism and rubberstamping.
  • Board dynamics and power dynamics.

Goals of an organisation

The main goal of a commercial organisation is to create wealth for its stakeholders. Also, for non-profit organisations, one of the critical success factors may be the goal of creating wealth, which may be a critical success factor in running day to day operations

To support goal, one needs to look into the critical success factors, which happen to be customer satisfaction, employee satisfaction and efficient operations and supply chains.

Also important is to keep tabs on sustainability (larger community), CSR (nearby community), fraud prevention (financial), regulatory compliance (government), risk prevention (short & long term), reduction in capital requirement, etc.

The effect

When the board takes care of these aspects, it attracts more business and investors. In turn, the requirement for funds is lower to efficiently and effectively run the business.

The assessment of role of independent directors

The assessment of the role of independent directors and their effectiveness for the growth and development of shareholders’ value in a firm is a crucial aspect of corporate governance. Independent directors, who are not affiliated with the management of the company, play a vital role in ensuring the interests of shareholders are protected and that the company is operating in a transparent and ethical manner.

One of the primary roles of independent directors is to provide oversight and guidance to the board of directors. They bring diverse perspectives, expertise, and experience to the board, contributing to informed decision-making. Independent directors challenge management assumptions, ask critical questions, and ensure that the company is adhering to its strategic objectives and legal obligations.

Furthermore, independent directors act as a check on executive compensation. They review and approve executive pay packages, ensuring that they are aligned with the company’s performance and that they do not incentivize excessive risk-taking. By doing so, independent directors help protect the interests of shareholders and promote sustainable, long-term growth.

Additionally, independent directors play a vital role in risk management. They review and oversee the company’s risk management policies and practices, ensuring that the company is adequately prepared to address potential challenges and opportunities. Independent directors also provide input on the company’s risk appetite and tolerance, helping to create a balanced approach to risk management.

Moreover, independent directors contribute to enhancing the company’s reputation and credibility. Their presence on the board signals to investors, customers, and other stakeholders that the company is committed to transparency, accountability, and good corporate governance. This can improve the company’s access to capital, attract top talent, and foster positive relationships with stakeholders.

It has been observed that financial performance improves with the presence of more and more independent directors to the tune of 5%, which corroborates the theory that independent directors monitor the performance of the organisation more effectively (Rosenstein and Wyatt, 1990) than management executives, who may have conflicts of interest with external stakeholders.

The large board takes more time to take decisions and, therefore, reduces the firm’s value.

Shareholders are fragmented and have an interest in making money, mostly through share trading. Also, the shareholders change frequently, so they do not have control over management. FIIs look to make money on investments and quit, so they do not look for long term attachment with management. This leads to a situation where decision-making remains with promoters and the management of the company. This means there is a need to keep an eye on insider management

Independent directors also balance the structure of the board, broadening the vision of the board and improving decision-making.

Independent directors, therefore, do not take specific decisions regarding day to day operations; rather, they monitor the decision-making by insiders.

The independent directors can thus also keep check on collusion between board of directors and management and the communication from management to the board members

The effect of independent directors has been studied by examining the impact of the introduction of independent directors on the level of operations or quality of governance of companies, as well as the relationship between the proportion of independent directors on the board and the characteristics of the company.

Also, if the ratio of independent directors is higher on the board, the disclosures are more regarding strategy and other information. Also, financial frauds and misappropriations are lower in listed companies.

There are also questions about the non-ability of independent directors to look beyond the familiar, i.e. new areas of research & development, innovations

Also, there could be some challenges related as the flip side of the coin:

The focus on ensuring the independence of independent directors is to establish a mechanism that protects their independence in the discharge of their duties

with regard to information, the Cadbury Committee emphasised that independent directors have the same powers to access information as executive directors and recognised that the extent to which independent directors fulfil their duties is closely linked to the quality of information they obtain

in terms of powers and responsibilities, the Cadbury Committee expects independent directors to be able to make choices in regulating the actions of the board and executive directors, and when there are conflicting potential interests

With the above goals and effects of the actions of the board and the role of independent directors, we shall assess them on the following accounts:

Quantitative:

  • Decide on current snapshot and trends of financial measures (net profit, ROI,  ROCE, P/E ratio, etc.).
  • Tobin’s Q Ratio
  • Attendance – availability for board and committee meetings

Qualitative:

  • Participation during meetings.
  • Interventions brought to table.
  • Experience in terms of years served on board and how many boards served!
  • Expertise in areas like audits, ESG, Compensation and recruitment, CSR, etc.

Conclusion

The presence of independent director on a board is relatively new regulation, although not a new concept. Independent directors have the challenging role of being a watchdog to keep a balance between promoters and other stakeholders and are supposed to ensure that the organisation generates and continues to generate wealth for the stakeholders in transparent and ethical way. There happen to be cha+llenges for independent directors as well. As spelled out above. The specific goals have to be spelled out and progress of the organisation is to be done for achievement of these goals and the way they are being achieved

The assessment of independent directors may be done on a quantitative and qualitative scale by themselves, their peers and other directors and stakeholders.

References

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