Independent directors: a burden or a solution?

During the 20th century, particularly from the 1970s onward, major corporate failures took place in the Western world for various reasons including, but not limited to, financial and accounting frauds. These scandals demonstrated that boards could sometimes be too close to management or may be acting in conjunction with each other’s interests, thereby compromising the effectiveness of the board. The concept of independent directors emerged in response to these fundamental weaknesses of the board members in corporate governance: it was thought that several US and UK companies that collapsed were widely associated with these serious corporate-governance weaknesses. The question of how to ensure that a company’s board should supervise management objectively, especially when management or controlling shareholders have strong influence over the board remained under discussion in the Western world for quite some time. It was widely discussed in the Western corporate world that if the directors themselves depend on management or have close relationship with each other, how they could be made more effective to safeguard the interests of the minority shareholders. This led to greater emphasis on the appointment of Independent directors who should have no material relationship with the company or its management. The United States through its stock exchanges initiated corporate-governance reforms by regulating the role of independent directors and shareholder’s rights. This led to the enactment of Sarbanes-Oxley Act of 2002. The United Kingdom followed suit, and the Cadbury Report (UK, 1992) was another major milestone towards this direction. It recommended that boards should include a meaningful number of non-executive directors who could bring independent judgment to the boards. The OECD Principles of Corporate Governance also emphasized to establish independent board oversight in line with USA and UK governance codes. However, it has been argued that despite all the above measures to improve corporate governance, the collapse of huge organizations in the USA and UK could not be averted. The list of corporate collapses included Enron in 2001, Tyco in 2002, WorldCom in 2002, LEHMAN BROTHERS in 2008. Most of these collapses were the result of frauds and bad governance, but ineffectiveness of the board to act was evident in every case. Enron and WorldCom are particularly important because they became symbols of a broader US corporate-governance crisis. LEHMAN BROS, for example, had a board, committees and formal governance structures, yet the board failed to adequately challenge the level of risk being taken. The collapse of Northern Rock, a well-known British bank in 2007, shocked everyone. That was indeed a blow to legislative measures that were enacted to improve corporate governance. BHS (British Home Store), another famous and reputable UK institution collapsed in 2016. This case is particularly interesting for discussion of independent directors. A UK parliamentary investigation team described this case as “a complete failure of corporate governance”. Its board failed to provide proper independent challenge to the controlling owner. Both of the above two cases, Northern Rock and BHS, are particularly interesting because boards and governance structures existed in both cases yet they could not prevent the eventual collapse. The Carillion, a British company, is probably another good example. Carillion had five non-executive directors on a seven-member board, and its audit committee was composed entirely of independent directors. Yet Carillion collapsed in 2018. A UK parliamentary inquiry concluded that the board was responsible and culpable for the company’s failure and described it as a “rotten corporate culture”. The case of Enron, a USA giant, is also interesting. Enron had a substantial number of outside/independent directors, yet the board failed to understand or adequately challenge the company’s highly risky business strategy and complex financial arrangements with the result that it collapsed. The lesson was drawn that simply enhancing the number of directors as independent would not prevent the collapse. It required much more than independent directors. The evidence from both the UK and USA shows that independent directors may have improved corporate governance even though there is no such evidence, but they have not been able to prevent major failures. In Pakistan, as we have a tradition to follow the Western world without weighing the benefits of new regulations, we also followed suit and introduced legislation to strengthen the effectiveness of boards. Section 166 of the Companies Act, 2017, which establishes the legal framework for independent directors, including their eligibility and selection, and Regulation 6(1) of the Listed Companies (Code of Corporate Governance) Regulations, 2019 with the specific provisions that make it mandatory for a listed company to have independent directors on its board. SECP enforcement orders expressly state that Regulation 6(1) requires every listed company to have at least two independent directors. Independent directors can be very helpful to a business, but only if they are genuinely independent, competent, and actively involved. Otherwise, they can become a legal and/or financial burden and may result in unnecessary delays in the decision making process of the board. They are particularly valuable for protecting minority shareholders from decisions that favor controlling shareholders. A strong independent board can increase confidence among banks, investors, customers, and regulators and provide valuable business judgment and alternative perspectives. It is argued that the adoption of new corporate governance rules has been a deterrent for our industrial, commercial and investment growth. That is why there has been almost negligible change in the number of listed companies over the last three decades. In addition, several well-known listed foreign companies opted for delisting. The reasons being their unwillingness to appoint independent directors on the boards, as they feel that it is not worth the cost due to poor contribution. They may be a burden if they do not understand the business or industry. The consensus is that they attend meetings but contribute little. They create unnecessary delays and bureaucracy. Their independence is only minimal. They have close personal or financial relationships with controlling shareholders, therefore their effectiveness is compromised. Their fees and administrative costs are high compared with the value they provide. This situation is evident with SOEs boards where independent directors are appointed on political basis and not on expertise. This has been the main reason of most of the SOEs failures. SOEs that enjoy monopolistic positions survived and made good profits but boards ineffectiveness was hidden due to their monopolistic position. Others facing competition could not survive. Pakistan Steel Mills and PIA went burst. Others, including various utility companies, are either struggling to survive or are about to go burst without the support of the exchequer. The general impression is that the independent nominated directors failed to perform due to their poor expertise and minimal contribution in the board. The quality of the director’s matters much more than simply having a large number of them. The appointment of independent directors may have strengthened overall governance, but they have not been a guarantee against corporate collapses. Their effectiveness depends much more on how independently and effectively they are selected, nominated and actually perform their role. Independence on paper does not mean independence in real terms. It is difficult to say whether the cumbersome regulations relating to appointment of independent directors do, in fact, provide a solution to improve effectiveness of the board. These regulations may be liberalized by mandatory allowing the minority seats on pro-rata basis through election. This should protect the minority interest as well as bring about an improvement in the effectiveness of boards. Thus, we may see more effective boards, better corporate results, improved payouts for shareholders and lesser corporate collapses. The growing medium-size companies should have a relatively small board containing limited number of really independent directors with specific expertise supported by strong financial controls and internal/external audit. This should give effective governance without creating unnecessary bureaucracy. (The writer is an Independent Director appointed by the federal government to the board of PNSC, a state-owned enterprise. He is a Chartered Management Accountant from United Kingdom and holds an LLB (Hons) and an LLM (corporate governance) UK) Copyright Business Recorder, 2026

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