Outside Director (Non-Executive Director) - Explained

What is an Outside Director?

Updated at September 25th, 2021

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What is an Outside Director?A Little More on What is an Outside Director Outside Directors and the Example of Enron Outside Directors and Corporate Governance Academic Research

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What is an Outside Director?

An outside director refers to an independent director of a company who is not an employee of the company. A member of a company's board of directors who is not a stakeholder in the company and has no financial relationship with the company is an outside director. Outside directors are entitled to sitting fees or annual retainer fees that the company pays either in cash or in stock. As part of the regulations for companies, the board of directors must comprise a percentage of outside directors because these directors give independent and unbiased opinions about matters arising in a company when compared to inside directors that owe their allegiance to the companies.

What Does is an Outside Director Do?

An outside director is otherwise called a non-executive director. In the United States, there are certain corporate governance standards that stipulate that outside directors must be present on the board of directors of every company. In the U.S, about 66% of boards comprises outside or independent directors. There are many benefits of having outside directors on a company's board of directors, these include;

Outside directors have outside and new perspectives on issues in a company.
They give unbiased opinions which might not necessarily be in favor of the company.
They have a minimal conflict of interests.

Despite the advantages outside directors bring to a company, there are some downsides of these directors such as lack of adequate incentive, insufficient information about the company, lack of access to classified information, among others.

Outside Directors and the Example of Enron

Outside directors play important roles in companies, this is why all companies must have a number of these directors on their boards. It is the duty of these directors to maintain their positions and also contribute to the growth and success of the company. Typically, outside directors help keep companies in check by performing oversight or checks and balances functions. In the case of Enron however, the outside directors of Enron derailed from their duties, enabling Andrew S. Fastow, a one time CEO of the company to enter shady deals that cause chaise for the firm. Outside directors faced out-of-pocket liability from the judgments and settlement that resulted from the deals.

Outside Directors and Corporate Governance

There are corporate governance standards and guidelines hat outside directors must adhere to, these guidelines will not only keep their companies in check but also help prevent frauds and shady deals by top executives or inside directors of the companies. Corporate governance contains clear policies that reduce risks and liabilities that a company and its directors are exposed to, these policies create a balance between the operations of a company and help in attaining its goals and objectives. It is essential that outside directors use corporate governance rules as measures of controlling their organizations.

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Academic Research

Corporate governance and the role of non-executive directors in large UK companies: an empirical study, Pass, C. (2004). Corporate Governance: The international journal of business in society, 4(2), 52-63. This paper studies corporate governance structures in the UK and scrutinizes the role played by non-executive directors in fostering best business practices. The Higgs Committee was appointed to reevaluate the role of non-executive directors as a measure to determine whether companies were still conforming to best practice recommendations and if financial irregularities were taking place.
The contribution of non-executive directors to the effectiveness of corporate governance, Clarke, T. (1998). Career Development International, 3(3), 118-124. This paper scrutinizes the role of non-executive directors while emphasizing that it is in a companys best interest to have outsiders in its board of directors. It also argues that shareholders cannot be considered viable counterforces to limit misuse of power by the board of directors. Finally, the paper reiterates the need to induct non-executive directors that add value to the business.
Board leadership, outside directors' expertise and voluntary corporate disclosures, Gul, F. A., & Leung, S. (2004). Journal of Accounting and public Policy, 23(5), 351-379. Gul and Leung sample 385 Hong Kong companies and subject them to regression analysis. As a result, the authors are able to establish correlations between: Board leadership structure in companies where CEOs also serve as board chairs (CEO duality). The percentage of specialist external directors on the board (PENEDs). Voluntary corporate disclosures.
Length of board tenure and outside director independence, Vafeas, N. (2003). Journal of Business Finance & Accounting, 30(78), 1043-1064.The author postulates and scrutinizes two opposing theories on the importance of the tenure lengths of non-executive directors. They are: The expertise theory, that prescribes extended service time on the board of directors as an indicator of loyalty, experience, and proficiency. The managementfriendliness theory, that hypothesizes that extended service time on the board of directors results in an unwarranted proximity between the non-executive directors and management, resulting in a compromise on shareholder interest.
Boards of directors: Utilizing empirical evidence in developing practical prescriptions, Dalton, C. M., & Dalton, D. R. (2005). British Journal of Management, 16, S91-S97. The authors perform a comprehensive analysis of corporate governance mechanisms and present a correlation between board structures and fiscal performance of firms. Their study concludes that not all best practices embraced by corporate governance structures conform to practicable scrutinization. The authors offer the following suggestions that will strengthen the sovereignty of corporate boards: Appointment of independent directors. Creation of independent budgets for boards of directors.
Do outside independent directors strengthen corporate boards?, Petra, S. T. (2005). Corporate Governance: The international journal of business in society, 5(1), 55-64. This paper seeks to challenge the prevailing corporate governance assumption that the presence of a majority of external independent directors reinforces corporate boards by keeping a close watch on management activities and securing the interests of stakeholders during management decisions. The authors conclude that there exists no factual evidence of benefits offered by external independent directors in strengthening corporate boards.
Nonexecutive directors: A question of independence, Clifford, P., & Evans, R. (1997). Corporate Governance: An International Review, 5(4), 224-231. The authors sample Australian corporate data and study disclosure requirements in an effort to determine attributes of non-executive directors. The study concludes that a third of the sampled non-executive directors were involved in undertakings with their respective firms that inherently curbed their independence. Such directors, coupled with insider directors together constituted a majority in their respective boards. This resulted in scenarios where internal management became the de facto controllers of the firms, in spite of there being a majority of external directors in the respective boards of directors.
Board composition, non-executive directors' characteristics and corporate financial performance, Grace, M., Ireland, A., & Dunstan, K. (1995). Asia-Pacific Journal of Accounting, 2(1), 121-137. This paper scrutinizes the performance of non-executive directors with a focus on their personal attributes and the overall composition of the board. The authors analyze samples of 86 Australian public businesses in order to draw a correlation between board structure and fiscal performance. They conclude that although a majority of the sampled non-executive directors was highly qualified, such attributes seldom affected the overall fiscal performance of the firms.
Nonexecutive Directors on Boards in Ireland: cooption, characteristics and contributions, OHiggins, E. (2002). Corporate Governance: An International Review, 10(1), 19-28. The authors sample data of 26 non-executive directors and chairpersons in Ireland and analyze their attributes. Their study concludes that non-executive directors are predominantly co-opted through social and business connections. Successful non-executive directors displayed the following attributes: Insightful thinking and problem-solving abilities; Potential for performance, both within and outside the boardroom; Hand-on business knowledge and experience.
Board size, executive directors and property firm performance in Malaysia, Shakir, R. (2008). Pacific Rim Property Research Journal, 14(1), 66-80. Shakir samples several prominent public companies in Malaysia in the period following the Asian financial crisis of 1997. He conducts a pragmatic analysis of the correlation between size of the board of directors, percentage of executive directors and the fiscal performance of the firms. Shakir concludes that Malaysian markets typically favor small boards with a higher representation of executive directors.
The CEO, the board of directors and executive compensation: Economic and psychological perspectives, Main, B. G., O'REILLY, C. A., & Wade, J. (1995). Industrial and Corporate Change, 4(2), 293-332. This paper discusses the criteria evaluated by large U.S. corporations while setting compensation levels for chief executive officers (CEOs). Several economic theories equate the presence of an independent board of directors to effectual preservation of stakeholder interest with minimal management opportunism. However, the authors investigation concludes that social influence is a potent factor that often comes into play, resulting in CEOs drawing much higher levels of compensation than can be estimated by such theories.

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Table of Contents

What is an Outside Director?

What Does is an Outside Director Do?

Outside Directors and the Example of Enron

Outside Directors and Corporate Governance

Academic Research

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