Independence Percentage of non-executive directors

The encouragement of good corporate governance has led to the creation of non-

executive directors (NEDs), who form part of the Board of Directors. In the UK, a

unitary board exists in companies, the board is made up of EDs and NEDs, also known as

insiders and outsiders. EDs are employed on a full-time basis by the company, with the

overall aim to oversee the daily running of the company, the transition to this role is

through internal promotion. NEDs are not full-time employees of the company, and are

appointed from outside of the company. Their role is to attend the monthly board

meetings, enhance shareholder value and provide a monitoring role (Institute of

Directors). In accordance with the Institute of Directors definition of director

independence, it occurs when directors have not been full-time employees, in addition the

directors hold no shares in the company whose board they sit on (Institute of Directors).

The introduction of the SOX Act in 2002 as a consequence of the global financial

scandals such as Enron and WorldCom, has meant that the NED role has become a

pivotal one to companies not only in the United States, but across the UK as well. The

NED role is not a direct result of the Cadbury (1992) report as it was the norm for

companies to be run by part-time NEDs. The guidelines state an NED is available to

work 100 hours per year (Charkham, 1994), while guidelines as to the number of boards

95

recommends significant changes to the board composition, these include an increase in

diversity, and the requirement that board members should have business and board level

expertise. The guidelines state that at least 50% of board members should be

independent. NEDs are also known as outsiders, independent and supervisory directors.

Hart (1995) states that ‘NEDs may owe their position to management.’ The appointment of NEDs in the UK is seen as controversial. Following the guidance of the Hampel report

(1998), The Higgs report (2003) indicates the process of appointing NEDs has high levels

of informality attached to it. “Almost half of the NEDs surveyed for the Report were

recruited to their role through personal contacts or friendship. Only 4% had a formal

interview, and 1% had obtained the job through answering an advertisement.” The

implications are that only quiet NEDs are appointed onto the Board of Directors (Hart,

1995), preventing the monitoring role from occurring. In the UK, 44% of boards consist

of NEDs (Peasnell et al., 2003), with 31% of the board being defined as independent. In

contrast, in the US, outside directors make up 76% of the board (Bhagat and Black, 1999)

and 77% (Klein, 1998).

The boards’ main role is to be vigilant; this can be increased due to the presence of NEDs. NEDs are seen as independent, and are not employed full-time by the company,

neither are they affiliated to the company whose board they sit on (Hermalin and

Weisbach, 1988). The central aspect of monitoring is to focus on the financial

performance of the company (Fama and Jensen, 1983). NEDs are more likely than

insider directors to dismiss CEOs following poor performance (Coughlan and Schmidt,

1985), and through maintaining their own reputation as directors, have an incentive to

monitor the board they sit on. In the UK, directors do not have fiduciary duties; NEDs

view their role as advisory as opposed to disciplinary (Franks et al., 2001). In the US,

96

fulfill their fiduciary duties, this is in contrast to the UK (Ozkan, 2007). NEDs are

delegated monitors who are appointed by the shareholders to monitor the manager’s use

of the company’s resources (Hart, 1995). NEDs concern for their reputation and future career opportunities, ensure directors are effective monitors (Fama and Jensen, 1983).

Agency theory (Jensen and Meckling, 1976) is still a valid theory; directors are motivated

to act in the interests of shareholders in situations whereby they have significant

ownership in the company (Morck et al., 1988; Jensen, 1993). Rosenstein and Wyatt

(1990) find for US companies that NED appointments lead to significant increases in

shareholder wealth; the relationship with capital structure is mixed, in terms of its

direction and significance. Previous literature suggests theories on how boards are

developed. Firstly, firm specific characteristics, such as company size, age of the

company, cashflows and scope of operations can determine how the board is shaped.

Secondly, owner specific characteristics that ensure the bargaining process between EDs

and NEDs occur.

A Board of Directors that contains a high percentage of outside directors performs a

monitoring role of the CEOs behaviour, and ensures incentives offered to the CEO are

also in the shareholder’s interests (Fama and Jensen, 1983). Young (2000) and Peasnell et al. (2003) find evidence that firm specific variables influence the board composition. Larger companies who have lower growth prospects are more likely to adhere to the

Cadbury Report recommendation on the number of NEDs. The period before equity

issuance, and following the departure of the CEO, also encourages companies to comply

with corporate governance guidance.

Previous literature has focused on the relationship between the number of outside

97

small positive relationship; Wagner et al. (1998) find an inverted U-shaped relationship,

while Dalton et al. (1998) find no significant relationship. One study (Dahya and

McConnell 2007) that considers the period following the release of the Cadbury Code,

1989-1996, finds improvement in the performance of UK companies. Companies that

add directors in line with the guidelines, report a significant improvement in operating

performance (Dahya and McConnell, 2007). In a study of UK companies Weir et al.

(2002) find a negative relationship between the percentage of NEDs and company

performance. Weir et al. (2002) find weak evidence between the structure of the board

and the performance of UK listed companies, arguing that companies should be given

greater freedom over the control mechanisms that they adopt. The difficulty with greater

choice is the ability to assess which controls are effective in ensuring good corporate

governance occurs. The impact on capital structure for UK companies has been

researched in previous UK studies; Faccio and Lasfer (1999) find a weak relationship for

a one-year time period, 1996/1997. The focus of this study is on the relationship between

the percentage of NED’s and capital structure with more recent data. 3.2.5.1 Percentage of NED’s Hypothesis

Agency theory (Jensen and Meckling, 1976) drives the relationship between the

independence of the board and capital structure, to avoid control of the decisions being

held by one person to ensure capital efficiency occurs. The choice between debt and

equity surrounds the different risk levels, and the additional uptake of debt should be

considered in relation to existing levels of debt. The risk of default increases as debt

levels increase, therefore the role of the NED’s is to ensure the managers are looking after the needs of the shareholders. The uptake of positive net present value projects is key to

98

NED’s provide an independent discussion surrounding the options available regarding capital.

In this study, the variable board composition is the percentage of NEDs a company has,

which is expressed as a percentage of the number of directors in total. Following the

guidance of the Hampel report (1998) the increase in NEDs for monitoring and control

purposes is seen as irrelevant, excessively costly and presents a threat to board unity

(Young, 2000). The impact of the increase in the percentage of NEDs on UK boards still

remains open for debate, this study seeks to identify whether the composition of the board

is one factor that contributes to a company’s choice between debt and equity.

As the number of NEDs increases, it translates to higher levels of monitoring, and leads

to the expectation of a negative relationship. The implications are managers wish to

avoid the high level of monitoring, therefore leading to the avoidance of high leverage

levels. Therefore, in line with Weir et al. (2002), to avoid the pressures and increases in

monitoring levels that are associated with servicing debt, a negative relationship is

expected.

The hypothesis is:

H11: There is a negative relationship between board independence and leverage.