Independence

Independent directors: Having a board of directors that are in some way linked to the company, whether they are former employees or current management, nullifies the role of the board.  The board is supposed to monitor management and therefore be independent.  Having independent directors on the board is important to maintain the board’s role and objectivity.  There have been a number of studies that show independent directors improve the monitoring function of the board (Rosenstein (1990); Nguyen & Nielsen (2010); Guo & Masulis (2015)).

  • Fulfillment criteria: Higher score awarded the greater the percentage of independent directors
  • Why this fulfillment criteria: As per literature
  • Scoring: 0=0-50%, 1=51%-65%, 2=66%-80%, 3=80%+

Average busyness of independent directors: Independent directors enhance the monitoring role of the board over management. However, if independent directors have multiple board appointments they may not be able to devote enough time to each board. This reduces the effectiveness of the monitoring role. Niu & Berberich (2015) find U.S. boards with independent directors who have multiple board roles are more likely to be part of companies that have governance problems.

  • Fulfillment criteria: Higher score awarded the lower the average board positions of independent directors
  • Why this fulfillment criteria: As per literature
  • Scoring: 0=more than 3, 1=between 2.25 and 3, 2=between 1.5 and less than 2.25, 3=less than 1.5

Independent directors only on audit committee: The board is responsible for ensuring a company’s financial statements are correct and representative of the company. The best way to achieve this is to have an audit committee composed solely of independent directors. Raghunandan, Rama, & Read (2001) look at the relationship between external and internal auditors. They find that audit committees solely comprised of independent directors are more likely to work with the internal auditor to monitor and review financial statements and audit processes. This means a more open and independent audit committee, key to monitoring management.

  • Fulfillment criteria: Independent directors only on audit committee?
  • Why this fulfillment criteria: As per literature
  • Scoring: 0=no, 1=yes

Nomination committee mostly made up of independent directors: As the job of the nomination committee is to hire and fire new directors and CEOs, a high level of independence is required. The choice of directors and CEOs will have a direct impact on shareholder wealth and therefore a level of independence is required to avoid conflicts of interest.  Shivdasani & Yermack (1999) find firms with CEOs (insider) part of the nomination committee pick less independent directors and so the monitoring role of the board is reduced.

  • Fulfillment criteria: Over 75% Independent directors on nominations committee?
  • Why this fulfillment criteria: As per literature
  • Scoring: 0=no or n/a, 1=yes

Independent directors only on remuneration committee: The pay of the CEO is an important part of aligning shareholder and management interests.  In order for there to be no conflicts of interest this decision must be made by those who have no affiliation with the company – independent directors.  If members of the committee are linked to the company there is an opportunity that remuneration will not be linked with company performance and therefore shareholder interests (Conyon & Peck, 1998).

  • Fulfillment criteria: Only independent directors on remuneration committee?
  • Why this fulfillment criteria: As per literature
  • Scoring: 0=no or n/a, 1=yes

Ratio of non-audit to audit fees: Auditors need to have independence from the company they audit so they can evaluate the financial statements in a fair manner.  If the audit company also does business with the company they audit, there is a conflict of interest.  If the auditing company provides a bad review of the company financial statements they could lose the custom of that company in the future (Frankel, Johnson, & Nelson, 2002).  Therefore, a high ratio of non-audit to audit fees increases the risk of the audit company losing their independence from the firm they are auditing.

  • Fulfillment criteria: Greater score the lower the percentage
  • Why this fulfillment criteria: As per literature
  • Scoring: 0=60%+, 1=46%-60%, 2=31%-45%, 3=30% or less

Max score for Independence category is 12.

References

Conyon, M., & Peck, S. (1998). Board control, remuneration comittees, and top management. Academy of Management Journal, 41(2), 146-157.

Frankel, R., Johnson, M., & Nelson, K. (2002). The relation between auditors' fees for nonaudit services and earnings management. The Accounting Review, 77(s-1), 71-105.

Guo, L., & Masulis, R. (2015). Board structure and monitoring: New evidence from CEO turnovers. Review of Financial Studies, 28(10), 2770-2811.

Nguyen, B., & Nielsen, K. (2010). The value of independent directos: Evidence from sudden deaths. Journal of Financial Economics, 98(3), 550-567.

Niu, F., & Berberich, G. (2015). Director tenure and busyness and corporate governance. International Journal of Corporate Governance, 6(1), 56-69.

Raghunandan, K., Rama, D., & Read, W. (2001). Audit committee composition, "Gray Directors," and interaction with internal auditing. Accounting Horizons, 15(2), 105-118.

Rosenstein, S. (1990). Outside directors, board independence and shareholder wealth. Journal of Financial Economics, 26(2), 175-191.

Shivdasani, A., & Yermack, D. (1999). CEO involvement in the selection of new board members: An empirical analysis. The Journal of Finance, 54(5), 1829-1853.