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I Introduction
In 2002, the UK government asked Sir Derek Higgs to carry out a review of the role and effectiveness of non-executive directors, in the light of concerns which had arisen about corporate governance in the wake of the collapse of the Enron company in the US. Sir Higgs’ Review of the Role and Effectiveness of Non-Executive Directors (hereinafter the Higgs Report) in January 2003 triggered a tide of debates about the roles that non-executive directors play in corporate governance.

This essay argues that the monitoring function of non-executive directors is an indispensable corporate governance arrangement for a unitary board to oversee and hold accountable executive management. Part II attempts to provide a historical context of the remainder by briefly reviewing the evolution of non-executive directors in the UK. Part III examines the strategic and monitoring roles of non-executive directors, with the latter playing an indispensable part in the context of corporate governance. Part IV attempts to figure out factors that may hinder the non-executive directors from performing their monitoring function. Part V examines recent developments of board monitoring in the UK, and argues for an intervention by the use of codes of best practice, with reliance on disclosure and market pressure as the enforcement mechanism. Part VI concludes the essay.
II Evolution of Non-Executive Directors in the UK

It is maintained that non-executive directors have been a feature of British companies from the earliest days of incorporation. As many non-executive directors were titled or public figures, they generally had no specific responsibility to manage or monitor the executive management, their role was to provide assurance to outside shareholders of public companies about the integrity of those managing the company.

Indeed, having the non-executive directors to perform advising and monitoring roles was undesirable by the end of the nineteenth century. The fact that it was until 1908 that Table A allowed a company to appoint directors to managerial positions exemplifies the situation. The reason laid behind is that a majority of the shares remained in the hands of the founder or his family, and ownership and control of British companies had yet to separate. Contrary to the conventional wisdom that stock market were flourishing in the United Kingdom from the eighteenth century onward, there were only a few companies with shares quoted on London's Stock Exchange in the 1880s. The replacement of family controlled companies by the Berle-Means corporations – widely dispersed ownership with strong managers – did not take place until 1950s, when the Berle-Means corporation gained its dominant position in the UK. 

With management separating from shareholders, it became necessary for non-executive directors to play a more active role. The non-executive directors’ function of bringing a degree of “outside” perspective to strategic decisions has developed, always taking the form of presence of representatives of company’s banks and other professional services provides on the board. It was evident, however, the non-executive directors were not perceived to perform a monitoring function to oversee and hold accountable executive management. 

Indeed, it was not until the 1970s that the idea that non-executive directors should perform a monitoring role was considered seriously. The impetus for the move was the perception that many British companies were badly managed and the difficulties to remove those responsible. Much has been done to make this change happen. The breakthrough took place in 1992, when Sir Adrian Cadbury in his momentous Report of the Committee on the Financial Aspects of Corporate Governance (hereinafter the Cadbury Report) endorsed the use of independent non-executive directors. The central role assigned by the Cadbury Report to the non-executives is “reviewing the performance of the board and the executive”.
III Roles of Non-Executive Directors: Strategy and Monitoring
To examine the roles of non-executive directors, it is always helpful to look at the definition. Despite the prominence of non-executive directors, there is no legal or statutory definition that is recognized in the UK. Section 741 of the Companies Act 1985 only defines a "director" as including any person occupying the position of director by whatever name called. This is a very unhelpful definition and fails to address the various types of director found in the modern reality of boardroom practice.

Nor does UK companies legislation prescribe functions of company boards; it is virtually silent about their structure and operation. The Higgs Report, avoiding precisely defining the term “non-executive director”, identifies two roles of non-executive directors, namely, monitoring executives and contributing to the development of strategy. This is in line with scholarly observation that “directors can assist with corporate policy-making and can monitor executives in a manner which should protect shareholders’ interests”. I will in the first place briefly deal with the first function, namely, the strategic function, then turn to elaborate the monitoring function of the board, in particular, its non-executive component.

The common practice in the UK is for a company’s articles of association to vest the board of directors with the power to manage the company. Table A, in fact, supposes that the board will be allocated a very significant role, for it provides in Article 70 that, subject to certain exceptions, “the business of the company shall be managed by the directors who may exercise all the powers of the company”. However, it may be incorrect that infer the board is the axes of corporate daily management. It is because the Companies Act 1985 allows a particular company to have the freedom to alter or exclude any provision in Table A, and because, in practice, the board tends to delegate its managerial powers to full-time executives, who assume the task of managing companies on a daily basis. 

Whereas directors, at least non-executive directors, do not manage companies, they provide the full-time executives with advice and counsel when executives set the strategy and overall direction of the company. Many non-executives are or have been senior managers with other business enterprises. Their experiences may allow them to bring into executives’ decision-making a wider range of knowledge and an fresh perspective and help to reduce the possibility of making flawed decisions.

The other – and more important but controversial – role of the board is to act as a “watch-dog” and monitor the management team to ensure they behave in a manner to advance shareholder value. The monitoring function comprises ex ante monitoring to detect and remedy problems before they materialise by pressing the incumbent management to make changes, and ex post monitoring to remove the key executives and find replacements who can address the problems. 

It has become a conventional wisdom that board monitoring helps to align the interests of the managers with those of the shareholders. Shareholders in large listed company are widely dispersed and relatively ignorant (because of free-rider problem), they are not in a position to exercise effective control over the company. The control of the company has thus passed from the hands of the owners of the company, its shareholders, and is vested in its managers. It is the basic presumption that one will act in one’s own self-interest, so there exists a divergence between the interests of the owners and managers without there being any effective checks on the power of the latter. An effective monitoring at the board level ensures managerial discretion is exercised in a fashion in line with shareholders’ interests.

Nevertheless, it is over-simplistic to come to conclude that board monitoring is indispensable in the context of corporate governance. There are a number of market mechanisms that may also operate so as to discipline managers and prevent them from under-performing. First, there is a primary type of market mechanism, that is, the market for corporate control – takeovers. Secondly, the capital market acts as a constraint on managerial performance. Thirdly, there is the product market. Lastly, there exists the market for managers, which motivates managers to perform in the interests of shareholders.

Although these market mechanisms address the divergence of interests, they may not substitute board monitoring. Taking the operation of takeover as an example, there is evidence to suggest that hostile takeovers are not in practice associated with poor pre-bid performance. The size of the bid premium and transaction costs, uncertainties stemming from inadequate information add to the difficulty to the operation of takeover. The collective action problem, the impulse to “race to the exit” and the “free-rider” problem impede institutional shareholder from intervention is another example of the failure of market mechanisms. Compared with market mechanisms, board monitoring of executives has the strengths, for example, that the board is more accessible to information and that it avoids the very considerable costs associated with takeovers. In short, monitoring of executives by non-executive directors is an indispensable institutional arrangement to improve corporate governance.

Before turning to examine the factors that may hinder the non-executive directors from performing their monitoring role, a few words should say about the potential tension between the strategic and monitoring roles of the board. Some commentators have questioned the feasibility to have someone who monitors the executives and who co-operates with them in the company’s strategic development at the same time. Whereas the Higgs Report acknowledged there might be a tension, it concluded there was “no essential contradiction” between the two roles. 

IV Factors Hindering Board Monitoring

While board monitoring has apparent strengths, it is does not follow simply that the presence of a number of non-executive directors on board will necessarily hold the executives in check. There are a number of hindrances that may impede non-executive directors from performing the perceived monitoring function.

The first hindrance is caused by the way that non-executive directors are appointed. Although the 1985 Companies Act says little about the means of appointing the directors and leaves this to the articles of association, it is the universal practice in the articles of association to require the directors to be elected by the shareholders. However, as a practical matter, the shareholders usually simply stamp their endorsement on a list of recommended candidates. Traditionally, the chairman of the board decided on who would be nominated and it was common for the chairman to serve concurrently as the top executive or the CEO. As a result, the top executive was picking up the non-executive directors who were charged with the task of monitoring managerial performance and who tended to owe their board positions to the patronage of the top executive. It may simply an illusion to rely on the non-executive directors to constrain the top executive under this governance regime. 

This flawed governance arrangement culminated in corporate scandals in the early 1990s, which prompted the Cadbury Committee and, subsequently, the Hampel Committee, to address the problem. The Combined Code, largely derived from the Cadbury, Greenbury and Hampel Report, explicitly requires, in principle, the CEO and the chair of the board should not be the same person, and the appointment committee on which the non-executive directors should be the only or the majority of the members should be introduced. Whereas this institutional arrangement makes the domination of the top executive less likely, it is cannot be comfortably predicted that the objectivity of non-executive directors are assured. For one thing, the CEO can often continue to play a significant “behind the scenes” role in selecting nominees. For another, the nominating committee, in order to avoid paralysing friction within the board, still seeks to nominate individuals who identify with the company’s goals and methods of operation and are compatible with the management team. 

Another fundamental hindrance to non-executive directors’ effectiveness to perform monitoring function is there lacks incentives for them to monitor at appropriate level. In the first place, non-executive directors are not financially motivated. Statistics has shown whereas the average remuneration of a FTSE 100 chairman is £ 426,000 p.a., that of a FTSE 100 non-executive director is merely £ 44,000 p.a. In a country where the “fat-cat” culture prevails, remuneration of this amount could hardly provides financial incentive for non-executive directors to act in a rigorous fashion. Another consideration is ideological disposition. As many non-executive directors are or have been senior managers with other business enterprises, they tend to have the preconceptions that the non-executive director monitoring should play a subsidiary role. Thus, the appointments committee may well screen out those with a strong attitude to the monitoring role and nominate individuals “fit in” the company.

Even though the above mentioned hindrances will to some extent be counter balanced by the considerations of reputational capital and legal liability, and non-executive directors are motivated to monitor the managerial performance, they may well find themselves in a position without the power leverage to make the change happen. The Combined Code merely requires at least one third of the board should be non-executive directors. Research conducted by the Higgs’ review indicates that, averagely, non-executive directors are in the minority. The fact that there is no requirement for all non-executive directors to be independent further weakens the power base of non-executive directors. It is true that whereas non-executive directors themselves may not be quite in a position to “rock the boat”, a coalition of institutional shareholders represents a significant percentage of the equity may strengthen their position vis-à-vis the management. However, the collective action problem may well frustrate such an attempt.

A further hindrance for non-executive directors is that they may not have access to company information; neither are they in much of a position to make use of it. Non-executives rely heavily on a flow of information provided by the senior management and the executive directors. The quality and accuracy of information determine the extent and degree to which non-executive directors may monitor and, if necessary, intervene. If the executives do not disclose the key facts or curtail the information supply, even the most motivated non-executive directors may not spot mismanagement. Even non-executive directors are well informed, their ability to oversee management is undermined by the fact that many directors are unable to devote sufficient time to the job. 

V Recent Developments of Board Monitoring: A Case for Further Intervention?

The hindrances mentioned above have impeded non-executives directors from pursuing their monitoring roles energetically in practice, and the mere presence of non-executive directors on a board itself is not an effective mechanism to constrain self-serving managerial discretion. There has been a sentiment that the failure of board monitoring is attributable to the declining competitiveness of British companies and to the increasing number of collapses of, and scandals in relation to, British companies.

To address the problem, reforms initiatives were carried out from the 1970s onwards to encourage the appointment of non-executive directors in greater numbers, of better quality, and with a more clearly defined role. It suffices here to summarise the board monitoring aspect of two landmark documents, namely, the Cadbury and Hampel Report, to outline the reform initiatives to strengthen board monitoring.

The Cadbury Report recommended that companies should have at least three non-executive directors, a majority of whom were to be independent, that the board as a whole should monitor the executive management, and that within the board the non-executive directors should bring “an independent judgment to bear” on, among other things, performance and key appointments. The Hampel Report went further to recommend that not less than one-third of the board should be non-executives, a majority of whom should be independent; that there should be a nomination committee; and that independent non-executives should be identified in the annual report. The position that the Cadbury and Hampel Report take was endorsed by the Combined Code. Although the Combined Code is a “soft law” and the “comply or explain” strategy imposes quoted companies only a disclosure duty, the Combined Code has been voluntarily complied with by most of larger listed companies.

As has been observed, although these initiatives introduced various counter balances to the executive management and put in place a board structure which would constrain unfettered managerial discretion, much still has to be done to strengthen the board monitoring. The question posed is whither to reform?

There is an influential school of economic analysis of company law, which regards the evolution of corporate governance structures as being determined by the requirements of efficiency. The Darwinian “survival of the fittest” struggle on the market will force companies to adopt the efficiently optimal model of board monitoring. There is no need for regulatory intervention unless there exists a market failure in the generation and dissemination of appropriate corporate governance arrangements. Moreover, whereas the theoretical case for board monitoring appears fairly strong, the empirical evidence on the contribution of non-executive directors to performance is equivocal. Bhagat and Black’s survey indicates the non-correlation between board independence and long-term firm performance and boldly suggests that firms with more independent boards do not outperform other firms.

These arguments seem plausible. However, a provocative new wave of law and economics scholars emerged in the last decade and advanced “political” theories that explained the evolution of corporate governance as the product of political forces and historical contingencies, not economic efficiency. This political theme is supported by recent empirical research on comparative corporate ownership structure. In response to the non-correlation argument, Romano has suggested a “weak” form of the monitoring hypothesis, supposing non-executive directors are likely to recognize only serious underperformance. Moreover, even if the efficiency theory of corporate law is valid, Parkinson’s study on the evolution of non-executive directors’ monitoring role in British companies suggests a market failure in the UK to develop a functioning board monitoring arrangement. There is arguably a case for further intervention to strengthen board monitoring.

There are generally two approaches for intervention: the prescriptive approach and the use of code of best practice. The Company Law Review Steering Group in their final report rejected the prescriptive approach that provides for non-executive directors and their roles in the statute. The Higgs Report endorsed the approach taken by the Cadbury Report, namely, the use the “comply or explain” strategy to spread best practice. It proposed a number of radical changes to the Code in order to strengthen board monitoring, which were largely endorsed by the Combined Code on Corporate Governance. These include: (1) except for small companies, at least half of the board should be non-executive directors; (2) a more explicit definition of independence is provided, which would, among other things, exclude a person who had been an employee of the company in the previous five years or had had a material business relationship with it in the previous three years ; (3) the roles of chair and chief executive should not be exercised by the same individual, and the chair on appointment should meet the impendence test, so that a retiring CEO should not go on the be the chair of the board ; (4) the role of the appointments committee and of independent executives on it should be strengthened ; (5) a senior independent director should be identified and be available for shareholders to contact if contact through the CEO or chair has failed to solve or would be inappropriate .
VI Conclusion
This essay has argued that monitoring of executives by the board, in particular, its non-executive component, is a desirable corporate governance control to hold the executives accountable and act in a manner to enhance shareholder value. The flexible strategy of using of codes of best practice in the UK, with reliance on disclosure and market pressure as the enforcement mechanism, proved successful in the light of generally high compliance with the code.

The Higgs Report has certainly had an impact on the monitoring role which non-executive directors play in British listed companies. More time will be needed to determine in a definitive way whether the impact is substantial and positive. For now it is noteworthy that even a compliance with the Higgs Report recommendations, as incorporated into the revised Combined Code, cannot prevent a corporate scandal from happening altogether. Notwithstanding, board monitoring, associated with other market and legal mechanisms, may bring into existence satisfactory monitoring arrangements to slow down the elongation of the already long list of notorious corporate scandals.


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