News
Recommended Practices in the Selection of Independent Members of Boards of Directors
04-Apr-2023
By: Alaa Abdul Aziz Abu Nab’aa* / CPA, CIA, CRMA, CICP, MACC
Director of Audit and Corporate Excellence Services at IFA, International Financial Advisors - Kuwait.
Corporate Governance Consultant in many companies in GCC and Jordan
Since its inception in the beginning of the 1990s, corporate governance systems have gone through many stages. In 1992, a report of the committee of the British House of Commons, headed by the Godfather of governance, Adrian Cadbury, was issued with the first definition of governance: “Corporate governance is the system by which companies are directed and controlled.” Since the issuance of the Cadbury report to date, the percentage of independent members in the boards of directors, along with the role stakeholders expect them to undertake, have remarkably increased.
The regulators have set requirements that should be met by independent members and have introduced special regulations that define the roles and responsibilities of the members along with the roles and responsibilities of the oversight committees of the boards. Moreover, the regulators have also defined different ratios of the independent members to the other members of the boards or committees in public entities, profit-making, and non-profit organizations, in order to maintain the required level of independence in the decision-making process, achieve the objectives of organizations and stakeholders, and ensure the sustainability of such organizations.
In this article, and away from the content of the regulations or rules of governance issued by the competent regulators in several countries, which have mostly defined the independence standards required for independent members, I will address some recommended practices regarding the selection of independent members; aiming to promote the effectiveness of boards and the oversight committees of boards, such recommendations include: Independent members should be able to accomplish the tasks assigned to them, express their opinions, vote on the decisions objectively and impartially. Regarding the percentage of shares owned by a member, he/she should not exceed, or be a relative of someone who exceeds, a certain threshold of shares (in joint stock companies). Similarly, the board member should not be a relative to any other board member or to any of the senior executive managers, also, the independent member should not work, or had been previously working, in the organization or with any relevant party related to it, such as external auditors and major suppliers. The independent member should not own a control interest in any of the above during a certain period, and he/she should not have a direct or indirect interest in the business or contracts relevant to the organization in which he works as a board member. Furthermore, independent members should not receive any financial compensations from their organizations, other than the remuneration he/she receives for being a board member or a member of a committee of the board. The independent member should not participate in or work for any competitor, and he/she should not have spent more than certain years (consecutive or discrete) as a board member of the competitor. These recommendations should be considered along with other requirements and standards.
The recommended practices in forming the boards of directors include:-
(1) The majority of the members should be independent.
(2) The board should be chaired by an independent member, or at least the deputy chair should be an independent member. One of the recommendations included in the “King IV Code of Governance” is that one of the independent directors should be selected to serve as a “Lead Independent Director” to enhance the objectivity and independence of the board. This is particularly applicable in the cases where the independence of the chairperson is jeopardized or doubted, in the situations where he/she works simultaneously as the CEO and the chair of the board, or where there is a conflict of interests.
(3) Additionally, the practical experiences, scientific knowledge, specialized skills, abilities, and personal traits (which are collectively known as “competencies”) of the independent members should supplement the competencies of the rest of the board members, whether executives or non-executives, and not duplicate them, so that the board as a whole is versed (has the ability to use knowledge in situations that are likely to occur, handle such situations without having to refer extensively to research and technical assistance from the executive management or from external consultants), in the following eight areas: domestic and international markets, industry, operations, laws and regulations, technology, accounting and financials, control, risk management. On top of that, each member should have the ability to detect the obstacles or anticipate their occurrence, determine the additional needed research, or the assistance that he/she should have from the executive management or external consultants in other fields such as management (organization, planning, direction, and control), governance, reading and understanding of financial statements and reports, economics, commercial law, taxes, and information technology.
The practices recommended when independent members carry out their duties and responsibilities include:-
(1) Each board member should seek to have a constructive conversation with the other members and the executive management, explicitly explain the reasons of objecting on a proposed decision, avoid using his/her authority to harm the interests of the organization or the other stakeholders, or to use it to achieve gains, whether directly or indirectly, or to achieve an advantage for another person related to him/ her, with the exception of obtaining remuneration for his/her membership in the board.
(2) All independent members should seek, as practical as possible, to acquire the needed knowledge about the business of the organization to be able to act effectively in the board of directors. This knowledge includes being familiar with the business and the market in which the organization operates, the key clients, the administrative structure, and those responsible for the management of the organization. Moreover, the independent board member should be aware of the confidential content, whether governmental or commercial, that he/she might see or read, as well as the terms and conditions that control the use of such confidential items. Additionally, the board member should have a certain level of knowledge of the production, technology, social, environmental, and financial aspects, as well as all the applicable laws and regulations to have a comprehensive understanding of the potential liabilities that may arise from carrying out the tasks of this role.
(3) The independent board member should visit the sites of the organization or the key production/ services areas.
(4) The independent board member should act as an agent to all stakeholders, therefore, the member should, within the limits of his/her authority, protect the rights and the legal interests of the stakeholders, assist in establishing an open channel for communication between the stakeholders, the board, and the executive management, in addition to the following:
(A) Understanding the expectations of the stakeholders and informing the organization of their expectations and opinions about the matters that are relevant to them.
(B) Seeking to ensure that the stakeholders obtain complete and timely information about the operations of the organization in accordance with the applicable laws, along with seeking to implement the rules of transparency within the organization and expanding the scope of additional voluntary disclosures.
(5) The independent board member should enhance his/her professional skills by participating in special training programs and the activities of the civil organizations that seek to improve the profession of independent board members.
The recommended practices in forming the control committees of the boards, such as the audit, the risk management, and the corporate compliance committees include the following:-
(1) The audit committee should be headed by an independent member, other than the board members, to avoid the bias to the board when, for example, there’s a conflict between the recommendations of the audit committee and the decisions of the board, or where the board disapproves a recommendation of the committee regarding the appointment of an external reviewer, the determination of the fees, the evaluation of the performed work, or the appointment of an internal audit executive. Furthermore, the audit committee shall undertake its important control activity, regarding the internal and external control, as well as compliance, risk management, and governance (even with the existence of other committees of the board that are specialized in such matters).
(2) The chairperson of the board of directors should not be a member in the audit or the nomination committees in order not to affect the objectivity of the decisions made by those committees regarding the evaluation of the effectiveness of the governance system within the organization and the nomination of members. However, the chairperson may participate in other committees provided that he/she doesn’t occupy the position of the head of such committees.
(3) Each committee should have a member of the board among its members to facilitate communication between the committee and the board without overcrossing the role of the committee's head in managing the relation between the committee and the board.
Through my knowledge of many governance systems in several developed countries, and so on; I noticed a discrepancy in the controls of forming audit committees and their subordination. In some countries, all committee members must be members of the board of directors (such as what is stated in the corporate governance system for public shareholding companies issued by the Capital Markets Authority in Kuwait). However, in other countries, the committees were allowed to include members from outside the board (such as what was stated in the corporate governance system for public joint stock companies issued by the Capital Market Authority in the Kingdom of Saudi Arabia). In Kuwait, the audit committee reports to the board of directors, and in Saudi Arabia, the audit committee reports to the general assembly that elected it.
Anecdotal evidence indicates that board members do not believe that actual independence must be linked to formal independence standards. An informal study by professors at Harvard Business School found that appropriate experience is a more relevant indicator of board member’s quality than compliance with regulatory requirements.
Board members are expected to demonstrate clear independence in order to be effective as an advisory and oversight body. The independence of a board member is assessed, from the organizational perspective, by the extent to which the member is free from the conflict of interests which may compromise the member’s ability to act for the benefit of the organization. Accordingly, independence is essential as it ensures that board members can and may take opposing decisions that contradict the decisions made by managements, when needed. The New York Stock Exchange (NYSE), for example, requires the listed entities to have a majority of independent board members in their boards and to have independent committees of auditing, remuneration, governance, and nomination.
However, the control standards (relevant to the selection of independent members) are not actually independent, as the board members who have been working with executive managements for long periods could have strong relations with such managements which is a crucial challenge to independence. Independence might be compromised due to individual factors, such as the level of competence, the values, and the personal relations between the board member and the executive management, as there are plenty of examples of boards that include competent members who did not object on the decisions made by executives, leading eventually to catastrophic implications on their organizations. For example, the board of directors of Enron failed to rein in the administrative actions that were proven criminal.