Are Independent Directors Effective Corporate Monitors? – An Analysis of the Empirical Evidence in the USA and Canada

Abstract

This thesis explores whether independent directors in the USA and Canada are effective in holding management accountable by: (1) analyzing how the policy of relying on independent directors developed and operates; (2) introducing the main theoretical critiques of independent directors’ monitoring effect; and (3) examining whether empirical studies in the field of management science and financial economics support the policy in both countries of relying on independent directors as corporate monitors. Empirical evidence shows that boards with a majority of independent directors, in some circumstances, were associated with better firm performance (in the post-SOX period) and fulfilled certain board tasks effectively in the United States. Canadian studies, however, have not shown a positive association with improved firm performance. Audit committees composed entirely of independent directors have been effective in ensuring the quality of financial reporting in the United States, but this effect has not been found in Canada. Compensation committees composed fully of independent directors neither constrained the level of executive compensation nor tied CEO pay to firm performance in either country. US firms with an audit committee member who had accounting expertise, rather than financial analysis or supervisory expertise, were associated with a higher quality of financial reporting, while Canadian firms with an audit committee member who has financial expertise, instead of financial literacy, were associated with a similar effect. Studies also showed that independent directors perform better in certain circumstances. Based on empirical evidence, US regulators should consider: (1) changing the current mandatory requirements for an independent board and a completely independent compensation committee to a comply-or-explain requirement; (2) narrowing the qualification of a financial expert to an individual who has accounting expertise; and (3) recruiting independent directors who have two or fewer outside directorships, hold more of the corporation’s shares, have lower cost of acquiring corporate information, and have no social connections with the CEO. In Canada, weak evidence of the monitoring effectiveness of independent directors supports the existing comply-or-explain approach. Canadian regulators may only need to require or recommend that at least one audit committee member has financial expertise, instead of only financial literacy.