16 May 2003 - Article written by Fabian Ajogwu, senior partner of Kenna & Associates, MSI's legal member firm in Lagos, Nigeria.

Introduction

The problem of how to make boards of directors more effective has been receiving greater attention in recent times, with the codification of best practices in corporate governance by governments, regulators and institutional investors all around the world. Drawing from best practices around the world, with special consideration for the local environment, Nigerian recently introduced its own Code of Corporate Governance for Public Companies in Nigeria produced by the Securities and Exchange Commission Committee on Corporate Governance (in which the author served as a Principal Consultant – www.secngr.org).

One of the central issues in this regard is how to ensure the independence of individual directors and of the board as a whole. To put this in perspective, it is worthwhile reviewing the duties of boards of companies. Most corporate governance texts agree that the main duties of the board are as follows:

• Ensuring that the interests of all the stakeholders are protected.
   

• To ensure that the company performs according to high business and ethical standards. The board has a responsibility to ensure that the proper objectives are set for the company and the management, and that a competent management capable of carrying out its duties is appointed. The board is also responsible for ensuring that they (the members of management) perform; assessing performance and taking action where necessary. At the same time the Board has the responsibility to safeguard the company’s values; to ensure that the management does not go against the company’s value system in carrying out their duties.
   

• To provide advice to management. Boards are increasingly being seen as being responsible to help management prevent problems and seize opportunities. They are expected to make an on-going contribution to the business, to defining and re-defining the business of the organisation (Charan, 1998)

If the board is to ensure that the interests of all the stakeholders are protected, they need to have a disposition of independence from the management and from any particular group of stakeholders.

Also, if the responsibilities of directors include the assessment of the performance of the company and of its management, and to take decisive action when necessary, they need to be independent from the management of the business.

Aspects of Independence

One aspect is independence of mind, as the King Report of South Africa states: “A candidate [to the board] should have integrity and independence of thought; the courage to express their independent thought…” This independence of mind is reinforced, although not necessarily assured by independence of position. By this, we refer to the absence of factors such as relationships that could create a conflict of interest, and so possibly undermine independence of thought.

A director that represents a major shareholder will be more concerned with his stake in the company and in a situation of conflict between protecting the whole company and protecting his investment or his principal’s investment, may opt for the latter. On the other hand, the code of Mexico and some other codes of best practice endorse the concept of patrimonial director, defined as a director that has a significant holding of the capital stock of the corporation. The provision is based on the assumption that such a director will maintain a permanent supervision of his investment, which will be for the benefit of the company, and all things being equal, for the benefit of the other stakeholders also.

In addition, some observers believe that directors might represent ownership interests better if they were significant shareholders themselves and thus personally identified with the shareholder perspective. It is also believed that this will strengthen their independence from management. Research carried out in the United States in 1993 indicated that 87% of the respondents had outside directors who owned shares in the company. However, the proportion of shareholding was still small; 58% reported that the percentage of total shares owned by the non-executive directors combined was less than 1%. It is also becoming a common practice to compensate directors with company shares. In a survey of companies in the United States, (Worrel, 1993) 47% of the respondents paid at least part of the compensation of directors in shares of the company.

There is a lot to say for the idea of directors being significant shareholders in the company. It is unlikely (though possible) that directors who are not shareholders and who do not represent a shareholder or group of shareholders will have a serious motivation for carrying out their duties as conscientiously as they can. Where most of the directors represent an interest or a group of interests it is obvious that they may emphasise their own interests at the expense of even the other shareholders.

Factors that affect independence

Despite differences in approach, many of the codes of best practice identify that the following have an influence on the independence of the board as a whole and of the individual directors.

Mix of executive and non-executive directors

All the codes of best practice agree that there must be at least some non-executive directors. Some codes specify proportions, ranging from 30% in the case of India, to 67% by the code drawn up in the US by the Council of Institutional Investors (CII). In Germany, this idea assumes the form of the two-tier board; a management board made up of executive directors, and a supervisory board, made up entirely of non-executive directors.

One of the functions of the board is to supervise management. If the board is dominated by executive directors, it is clear that the monitoring and executive functions will become fused. Non executive directors are more likely to assess the performance of the company and the management from a more neutral standpoint. The Code of Practice on Non-Executive Directors drawn up by the Institute of Directors of UK required the non-executive directors to monitor executive performance against agreed goals.

In Nigeria, the Companies and Allied matters Act 1990 (CAMA) does not make any provision in this regard. However, our review of data from 149 quoted Nigerian companies indicated that the average proportion of non-executive directors was 78%, the maximum proportion being 91% and the minimum, 20%. It is not a matter however of prescribing a particular proportion of non-executive directors. The guiding principle, in making a judgement about the specific proportion should be, as the Cadbury Code of Corporate Governance states, to ensure that the “calibre and number of non-executive directors [is such] that their views will carry significant weight in the board’s decisions.”

Independence of non-executive directors

Having a majority of non-executive directors on the board will not necessarily guarantee the independence of the board. The independence of the individual non-executive directors is another issue. Here also, the Companies and Allied Matters Act does not have any specific provisions, although there is a hint in section 279 (6) in the form of a statement that a director should not fetter his discretion to vote in any particular way.

The system a company has in place for the appointment of new directors has a very important role in safeguarding the independence of the directors so appointed. A statement by a one time chairman of ICI, in an interview related in Parkinson (1993) is a good starting point: “…on hearing of a possible candidate (for position of non-executive director) the first thing that you do is talk to a mutual friend,’ …..it is important to ask whether the potential director is ‘the sort of person you could get on with.’ While there is no denying that it is important for the management and the non-executive directors get on well with one another, in the sort of situation described above, it is unlikely as Parkinson observed, for the non-executive so appointed to be assertive.

Most of the governance codes prescribe the use of a nomination committee, made up mostly of non-executive directors. The function of the nomination committee is to carry out the selection of new directors. Nomination committees are not common in Nigeria. In a survey of 25 companies, which we carried out, only three of the respondents had anything that came close to a nomination committee. The average proportion of non-executive directors in the nomination committee was 68%.

One could consider that if the present non-executive directors are not independent, then it is unlikely that they would recommend independent candidates. An interesting finding from our survey of publicly quoted companies in Nigeria was that out of 25 respondents only 5 indicated that they provided biographical details of nominated directors to the shareholders. We certainly do not imply that providing biographical details of nominated directors solves the problem only that this gives an idea of the seriousness of the voting done by the shareholders at the annual general meeting.

It is difficult, if not impossible, to give a comprehensive solution. At the end of the day, the effectiveness of the nominating committee will depend on its composition and on whether there is a genuine effort to ensure independence. One must also say that the shareholders ought to play a greater role in selecting the directors, if independence is to be assured.

Several codes of best practice have identified situations that may compromise the independence of a non-executive director. Common elements among all the codes are that an independent director is one that:

• Is not closely connected with significant suppliers, distributors, customers, financial advisers or bankers.
   
• Has not been in the employment of the corporation within a defined specific period, up to five years in some cases.
   
• Is not a member of the immediate family of an individual employed by the corporation as a senior executive, also within a certain period.
   
• Is not affiliated with any tax-exempt entity that has received from the company, significant amounts of money.

It is important to clarify at this point that we do not propose that all the directors must be independent. However, the board and the shareholders have to identify which of the directors are not independent in order to ensure that the director does not take advantage in a conflict of interest situation. Even assuming the best intentions, it is clear that one who is in a potential conflict of interest cannot assure even himself that he will maintain an independence of mind in addressing issues, particularly those that relate to the board’s function of balancing stakeholders’ interests. Moreover, a director who has personal, family or financial ties to the company’s management will find it difficult to challenge management’s proposals, or to ask tough questions required of an independent board.

Combination of the positions of chief executive and chairman

Another situation that will affect independence, now more at the level of the board as a whole, is the combination of the position of chairman and chief executive in one person. While none of the codes of corporate governance practice or regulation prohibits this, it is a situation that is frowned upon by many. The reasons for this position can be summarised as follows;

• The separation of the two positions strengthens board independence. In 1999, the board of Compaq Corporation removed its chief executive for consistent under-performance. Without going into the fairness of this action, it is obvious that this may not happen in the case of a chief executive that is also the chairman of the board.
   

• The board’s chief responsibility to look after and ensure the balancing of the stakeholders’ interests will be compromised if the positions are combined. Management is often a party in the situations of conflict among various interests, for instance in a conflict between the interests of the employees and the interests of the shareholders. If the board is led by the chief executive officer, there will be a potential conflict of interest here.
   

• As we have identified earlier, the board has a function of overseeing and monitoring management performance. Needless to say that the board will most likely not do this effectively if the positions are combined.

Consequently, most codes prescribe that where the chairman is also the chief executive of the company, there should be a ‘strong independent element’ on the board. In Nigeria, the Companies Act simply provides in this respect that the directors may elect one of themselves to act as the chairman of the board, and preside over board meetings. The Act is silent on whether or not the chairman should be involved in the day to day running of the organisation.

Out of the 149 companies whose data we reviewed, only 19 had a combined chairman/position. We discovered that there were essentially two types of companies in this position. The first type was the fully indigenous company, with a founder/CEO. The second was made up of partly foreign owned companies. In many of the cases, there was a clear sign of a strong independent element on the board, in the form of foreign non-executive directors. It is also important to note that the companies whose data we reviewed consisted only of quoted companies. Even though we do not have the necessary empirical data, it is likely that the proportion of companies that have these positions combined would be much higher if the scope of the sample were expanded.

There are however arguments for combining the two positions (Charan, 1998):

• Separating the two positions will lead to confusion among managers as to where decision-making authority lies for some matters.
   
• It will create a new layer of management requiring additional information and reporting burdens
   
• The position of chairman would amount to a ‘superior director’ position – an affront to the other outside board members
   
• Defining a meaningful job for the chairman that does not overlap the role of the chief executive will be difficult.

While these are valid concerns, they will only arise if there is confusion in roles. Contrary to the assertion above, this confusion is not inherent in the situation. The role of the chairman, according to the Cadbury report, is to ensure that the board is working well and living up to its responsibilities. Accordingly, the chairman should keep away from day-to-day running of the organisation to maintain the perspective needed to ensure that the board is in full control of the company’s affairs.

As explained by the National Association of Corporate Directors in the United States, “the purpose of creating an independent leader (of the board) is not to add another layer of power but to ensure organisation of the thoughtful execution of certain critical independent functions.” Such functions include evaluating the performance of the chief executive and the management, leading the board in crisis, and determining the remuneration policy for the top management.

The chairman has to work in such a way as not to undermine the authority of the chief executive officer. The work of the board is to select the chief executive and give him support. It is important for the whole company to perceive unity between the board and the chief executive, but a board that does this at the expense of the stakeholders has abdicated.

Conclusion

In whose interest does it lie to ensure that the board’s independence is maintained?
It is clearly to the benefit of the board itself and to directors concerned with fulfilling their duties conscientiously. It is of benefit to the shareholders especially those who do not have a seat on the board. It is of benefit to the other stakeholders, who are assured that the board will ensure that their interests are protected. It is of particular importance to the society, since it will create the environment for corporate success and investor confidence.

Surprisingly, it is also of benefit to the management. In an interview with several chief executives, the following advantages for the chief executives were identified:

• Chief executives benefit from being accountable to an able board, since the discipline helps them keep their eyes on the right goals
   
• A questioning board can prevent a chief executive from making a big mistake
   

• Having to convince a strong board to go along with management plans forces the management to think through those plans and do the necessary homework to justify them.
   

• Chief executives need all the help they can get.

However we are faced with the fact that those whose behaviour is most in need of reform are the most unlikely to seek reform. A board that is not independent of management is unlikely to want to secure independence. The same logic applies to a management team that is not accountable to an independent board.

The answer to this is a sound code of corporate governance guidelines with clear criteria for evaluating independence of individual directors and boards. The new Code of Corporate Governance for Nigerian companies should hopefully provide guidance on the best practices for our companies. The guidelines have to be drawn up by or in consultation with business leaders and associations of directors and enforced partly by regulation and partly by pressure from professional bodies and shareholders, especially institutional shareholders.