One typical problem boards of directors face is the conflict of interest, where individual interests compromise the directors’ judgment. The solution, however, is having an independent group of individuals within the board with no vested interest who can offer unbiased oversight and render an independent ruling. That’s where independent directors come in, and their role in corporate governance is quite critical.
Independent directors, however, are more than just nonpartisan when offering oversight or rendering judgment. They help with strategic direction, performance review, compliance oversight, and succession planning, to name a few of their contributions to the board of directors. Independent directors do all that despite not being part of the company’s day-to-day management as their counterparts (executive directors) are.
This guide will help you understand how the two groups of directors differ. More importantly, we’ll discuss the role of independent directors in more detail, the benefits of having them on board, the challenges they are likely to face, and future trends in corporate governance involving them. Let’s dive in!
Key Takeaway:
- Independent directors are members of the board who aren’t involved in the company’s day-to-day management. They are neither company employees nor have vested interests in the company.
- Notable roles played by independent directors include strategic direction, performance evaluation, resource allocation oversight, compliance surveillance, board enhancement, professional development, meeting participation, risk management, financial oversight, succession planning, stakeholders’ interest protection, reputation management, board remuneration, and independent ruling.
- Board independence benefits corporate governance by promoting unbiased oversight, reducing conflict of interest, enhancing decision-making, improving accountability, advocating financial integrity, encouraging future preparedness, and attracting investors.
- Independent directors face several challenges, including independence maintenance, information asymmetry, time constraints, board dynamics, regulatory scrutiny, and conflict of interest.
- Expected future trends in the role of independent directors include an emphasis on ESG, digital transformation, and broad stakeholder engagement.
Who Are Independent Directors?
According to NSE, an independent director is a board member with no material relationship with the company, either as a shareholder, partner, or executive officer.
On the other hand, NASDAQ defines an independent director as a member of the board who’s not an employee or executive of the company and has no relationship with the company that could compromise their right to exercise independent judgment.
With that in mind, independent directors, sometimes known as outside directors or non-executive directors, are members of the board of directors who are neither part of the executive team nor have material relationships with the company and aren’t involved in day-to-day management.
Qualities of Independent Directors
Independent directors possess several unique qualities that make them effective at their jobs. These qualities include:
- Strategic thinking
- Critical evaluation
- Independent mindset
- Industry knowledge
- Leadership skills
- Time commitment
- Team building ability
- Problem-solving ability
- Ambassadorial potential
- Practical communication skills
What’s the Role of Independent Directors in Corporate Governance?
Independent directors are essential in a company’s effort to observe good corporate governance. Their contribution to the boardroom is indispensable, and here are the roles they play:
1. Strategic Direction
Independent directors help formulate and review a company’s strategic objectives. They offer impartial perspectives, which aid in harmonizing a more solid strategic plan. Independent board members also help set standards and core values to help the company attain its strategic business strategy.
2. Performance Evaluation
Outside directors assist with overseeing a company’s performance and determine whether it is meeting its strategic objectives. They thoroughly assess the performance of senior management and executives to ensure they all work towards promoting the company’s agenda and protecting stakeholders’ interests.
3. Resources Allocation Oversight
Independent directors help monitor the allocation of essential company resources, especially capital. They ensure the allocation is transparent and fair and for a good course. It holds the rest of the board and the senior management accountable for how resources are utilized in the company.
4. Compliance Surveillance
Non-executive directors monitor a company’s efforts to observe laid-out regulations and regulatory requirements. They are often the first to pinpoint noncompliance issues. Once they raise an issue with ethical compliance with the rest of the board, they try to find an answer as quickly as possible.
5. Board Enhancement
Independent directors help improve the board’s structure and composition. Through board discussions, they can offer meaningful insights into how well the board can work and areas that executive directors can improve or pay extra attention to. In the long run, these directors make the board more efficient.
6. Professional Development
Independent directors may undergo independent training at the company’s expense to fulfill their new responsibilities and then use the knowledge acquired to advise the rest of the board during board meetings. Developing their proficiency and board knowledge is similar to developing the board’s proficiency and expertise in corporate affairs.
7. Meeting Participation
Independent directors are expected to attend board meetings and provide their viewpoints, research, and insights, which could help the board address a particular challenge. Remember, while they may not be on a salary, they earn a sitting allowance and sometimes transport allowances, which only apply when they attend board meetings.
8. Risk Management
Outside directors can help identify risks that could negatively impact the company’s business operations, especially those touching on finances, business strategy, and ethical compliance. Moreover, they offer vital insights on mitigating the risks and protecting the company’s and stakeholders’ interests.
9. Financial Oversight
Independent directors oversee an organization’s financial reporting exercise and thoroughly examine the financial statements and audit records to ensure accuracy and compliance. They also examine the internal control measures to protect the company’s financial resources and prevent issues such as fraud.
10. Succession Planning
Independent directors help formulate succession plans for key executive positions like the CEO, COO, and CFO. They also help identify potential candidates, assess their suitability, and oversee their inclusion in the company. Since they are nonpartisan, they are expected not to be swayed by any personal interest when crafting the succession plan.
11. Stakeholders’ Interest Protection
Independent directors are appointed by shareholders to protect their interests, especially those of minor shareholders who don’t have direct representation on the board. This is unlike inside directors, who may serve as executives at the company and, therefore, can protect their interests.
12. Reputation Management
Outside directors help to boost and protect a company’s image by ensuring the interests of all stakeholders are protected. In a crisis, they are always ready to offer their expertise to mitigate the risks and protect the company’s reputation from getting dragged into a messy ditch.
13. Board Remuneration
Independent directors help identify and appoint suitable candidates for the executive board. Their nonpartisan contributions make them more appropriate, as personal interests don’t easily sway them, as with executive board members. Moreover, they can help remove a board member from office, such as a non-performing and fraudulent executive board member.
14. Independent Ruling
Since independent directors have no material relationship with the company they serve and aren’t directly associated with key shareholders or senior management, they offer a more independent judgment. In a crisis, they can step in and provide an unfettered ruling in the absence of the chair or when the board can’t reach a common ground.
What’s the Difference Between Independent Directors and Executive Directors?
Independent directors differ from executive or inside directors in several ways. Let’s explore them:
a) Day-to-Day Operation
Generally, executive directors are actively involved in the company’s day-to-day management. Some of them hold titles like Chief Executive Officer (CEO), Managing Director (MD), Chief Financial Officer (CFO), and Chief Operation Officer (COO). In contrast, independent directors aren’t involved in the company’s day-to-day running. They only offer oversight and guidance.
b) Employee Status
Unlike executive directors, independent directors aren’t part of the company’s staff. They don’t hold notable titles like CEO, MD, CFO, or COO and are just board members.
c) Material Interest
Independent directors typically have no material interest in the company they serve as board directors. They also don’t directly associate with key shareholders, partners, and top management so as not to fall victim to the conflict of interest, unlike executive directors, who may have material interest and direct association with key stakeholders and senior management.
d) Independence
Independent directors, as the name suggests, are independent. They are expected to offer impartial insights and perspectives during board meetings, focusing on protecting stakeholders’ interests, particularly minority shareholders, without a loud voice in the boardroom.
Executive directors, in contrast, often align their insights and perspectives with their internal interests and can be susceptible to conflicts of interest.
e) Accountability
Though executive and non-executive directors are accountable for the decisions and actions the board takes on behalf of shareholders, executive directors hold a higher level of responsibility. They are more responsible for the company’s success or failure than independent directors.
f) Compensation
Executive directors are highly compensated as company employees. They are often the top earners in a company. At the end of the month, they receive a salary for running the company in their various executive capacities, such as the CEO, MD, and COO.
On the other hand, independent directors may receive an annual retainer fee, sitting allowance, commuter allowance, or even reimbursement for company-related expenses, but that’s it. They are, however, not placed on a monthly salary as they aren’t company employees.
g) Time Commitment
Executive directors are almost full-time employees. If they aren’t in the boardroom deliberating, they are probably in their office or somewhere meeting investors and exploring new markets and investment opportunities for the company.
In contrast, independent directors only show up when necessary or when called upon. They aren’t available full-time as most of them are likely to juggle between several boards of directors and companies.
h) Key Roles
The key roles of executive directors include day-to-day operation management, decision-making, goal setting, financial oversight, budget management and review, policy development, and stakeholder engagement.
In contrast, the critical roles of independent directors include strategic advice, setting board remuneration, appointing and removing executive board members, and governance oversight.
What Exactly is Board Independence and Why is it Important?
Board independence is a term that describes the existence of directors on a given board who aren’t affiliated with the company, the management, or major shareholders. Simply put, it’s the existence of independent directors.
Board independence is a hallmark of effective corporate governance due to its positive impact in the boardroom. Here’s how independent directors benefits a company’s corporate governance efforts:
a) Unbiased Oversight
Independent directors aren’t associated with key shareholders, partners, or senior management. Therefore, they can provide impartial oversight of the company’s critical operations to ensure everything is working as expected and that major hiccups are addressed by those responsible.
b) Reduced Conflict of Interest
Since independent directors have no material relationship with the company, they can avoid personal interests when making suggestions to the rest of the board. Furthermore, their presence on the board stops the executive board members from pursuing individual interests.
c) Enhanced Decision-Making
Considering that independent directors come from diverse backgrounds and have different experiences and expertise, they offer diverse viewpoints to help the entire board make a more favorable decision.
d) Improved Accountability
Independent directors hold the executive board more accountable for its decisions on behalf of stakeholders and the company. They demand accountability and transparency from the executive board and senior management, which keeps everyone on their toes.
e) Financial Integrity
Independent directors have a critical role in facilitating transparency and accountability during financial reporting and auditing, and in doing so, they can prevent fraud and other issues that could erode the board’s financial integrity.
f) Future Preparedness
Through succession planning involving talent search and management, outside directors help the board and the company prepare for future endeavors. They also help with future preparedness by providing strategy oversight, where they help the board set long-term goals and pursue them.
g) Investor Attraction
By improving the board’s integrity and image, independent directors make the board more attractive to investors who trust it with their money. As investors become more confident of the board’s uncompromised integrity, financial accountability, and ethical compliance, more are likely to invest.
Challenges Facing Independent Directors in Corporate Governance
Although independent directors are vital corporate governance promoters, their jobs can be challenging. Here are some of the hiccups they have to contend with:
a) Independence Maintenance
Independent directors are called so because they are expected to enjoy genuine independence. We expect them to make nonpartisan and free-will decisions. They should be neutral in their submission at board meetings and objective-driven.
Sometimes, however, these directors find it hard to enjoy their independence as they suffer pressure from stakeholders and senior management with whom they’ve built a robust working rapport. Others get involved at a personal level, which compromises their independence.
b) Information Asymmetry
Outside directors, like inside directors, rely on senior management for information they can deliberate on before arriving at a decision. Sometimes, however, they may fail to get all the information they require, perhaps because they do not have the same deep insights as the executive board, which limits their ability to contribute effectively.
c) Time Constraints
Most independent directors serve on multiple boards and find it challenging to give them equal attention. Some boards may suffer because the directors under-commit their time, and that’s not good for the company’s well-being.
d) Board Dynamics
The boardroom should be a collaborative environment where all directors can freely express their diverse viewpoints. Sometimes, however, the two sets of directors may have strong but varying views, making it hard for them to find a common footing. Finding the elusive balance may alienate some directors, which isn’t good for the board’s image.
e) Regulatory Scrutiny
Boards of directors, including independent directors, occasionally face scrutiny from regulatory entities. This will likely be the case when dealing with ethical compliance and financial reporting matters. Consequently, the board members must be on their toes to ensure they are always compliant.
f) Conflict of Interest
Although independent directors enjoy some level of independence, especially when making decisions, their involvement or association with other close associates and stakeholders may prompt material interest. Their interests may change and conflict with the ethical standards they are supposed to observe.
Future Trends in Corporate Governance and the Role of Independent Directors
Corporate governance dynamics are quickly changing, and so are the roles of independent directors. Soon, these are likely to be the common trends:
a) ESG Emphasis
Each day, ESG (environmental, social, and governance) commitment continues to be a fundamental pillar of corporate strategy, and we expect an increased emphasis in the future. More and more external stakeholders, especially customers, government agencies, and investors, will pressure companies to demonstrate their ESG commitment and reveal the actual results.
As a result, independent directors will have to polish up their ESG understanding to help the companies they serve stay compliant.
b) Digital Transformation
Digital transformation is already reshaping the corporate landscape, and it’s only a matter of time before all companies are fully digitized. In the future, companies, through their boards, will not only have to accept fully but also utilize AI technology, machine learning, and cloud computing as part of their day-to-day operations.
c) Wider Stakeholder Engagement
The name stakeholder now has a broader meaning. Internally, it includes the company owners and employees; externally, it includes investors, customers, creditors, suppliers, trade unions, communities, and regulatory bodies.
In the future, more of these parties will be engaged in the day-to-day running of companies. All directors, including independent directors, will be all hands on deck to ensure nothing slips their grasp and that all stakeholder viewpoints are considered.
Wrapping Up!
There’s no denying the role of independent directors in corporate governance. Though they may not be directly involved in the day-to-day management of the company as executive directors are, their independence and ability to offer nonpartisan oversight and ruling make them critical to the board’s success.
Despite the challenges, all boards need them. We at the Center for Corporate Governance understand that, and we would love to share our expertise with everyone interested in adopting a proper corporate governance structure. That includes companies looking to recruit independent directors and understand their roles.
As a leading corporate governance institution in Africa, we aim to help corporate organizations unlock their leadership excellence through training. Our website provides details of our monthly mastery course on corporate governance. Visit us today!
