UK: The Aftermath of Enron: A Corporate Governance Action Plan

As the ripples from the Enron collapse spread ever wider, what should UK listed companies be doing now in response to the corporate governance issues that have been raised? The reviews being undertaken by legislators and regulators in the UK, Europe and the US will eventually no doubt give rise to regulatory changes covering corporate governance, accounts and auditors. However, directors of listed companies should not just be waiting for these changes, they should be considering now what practical steps can be taken to improve corporate governance in order to implement best practice and reduce risk. This briefing looks at the key corporate governance issues that have arisen out of the collapse of Enron and sets out the range of matters that we think boards should be reviewing.

The composition of the Board and Non-Executive Directors

The Combined Code makes it clear that the board should have a good balance of executive and non-executive directors. The role of non-executive director in particular has come under fierce scrutiny as a result of the collapse of Enron. Much has been written about the role and responsibilities that non-executives should take on and how their role and independence can be enhanced. Whether this results in a consensus for change remains to be seen – there have been many contradictory proposals (ranging from giving much more responsibility to non-executives to abolishing the non-executive altogether…). What boards can and should do at this stage is review the basics of the company’s board structure:

• Is the balance and division of responsibility at board level clear and appropriate?

• Is the balance between non-executives and executives right?

• Does the board have a sufficient number of fully “independent” non-executive directors? The focus is shifting from the technical concept of independence to the need for non-executives to also be truly independent in the sense of a willingness to make contrary views known and to stand up to management.

• Are the skills and experience of the non-executive directors right for the company’s business?

• Has a senior independent non-executive director been nominated and is that person a strong force within the board who takes a lead on issues of concern to the non-executive directors?

• Are the right matters reserved to the whole board having regard to the company’s business and size?

The standard terms of appointment for non-executive directors should be reviewed:

• Do these comply with accepted best practice, for example in relation to having a fixed term of appointment, and do they properly set out the duties of the director?

• Has the board agreed with each non-executive director how much time he or she should be devoting to the company’s affairs? Is the board satisfied that the time is set at a sufficient level and how does it monitor this?

The remuneration of non-executive directors is another topic in the spotlight. Some argue that if non-executive directors are expected to take on more responsibility and importance, they should be paid a lot more. Others argue that in order to be truly independent non-executives must not be reliant on any particular level of remuneration from a company.

• Companies should not just increase the remuneration of the non-executive directors without considering what additional contribution needs to be made by them in order to justify that increase. Instead, the board should review the remuneration arrangements for each non-executive director and make sure that these reflect the duties assigned to that person and his or her level of contribution – or if the duties or contribution are to be increased, to reflect that increase.

• Some companies have also been considering alternative methods of remunerating non-executive directors, particularly remuneration in shares. There is opposition from investor bodies to the grant of share options to non-executive directors because it is seen as tainting their independence and aligning their views too much with the executive directors. In contrast, the issue of shares to directors is considered by some to align the interests of the non-executives with those of shareholders. There are a number of technical and structural issues to be considered if non-executive directors are to be paid in shares – for example to avoid financial assistance issues.

Companies should be reviewing their directors’ and officers’ indemnity insurance:

• Having proper insurance cover in place will be a factor in finding and keeping good directors in a time of increasing shareholder activism and litigation.

• The review should encompass whether the level of cover is adequate, who is covered and for what periods, whether the right risks are covered and exactly what the exclusions are.

The Combined Code requires listed companies to create an audit committee, a remuneration committee and a nomination committee to which particular responsibilities should be assigned. Companies should consider how these committees operate and who the members are:

• There should already be a formal written remit in place for each committee but this should be reviewed to ensure that the responsibilities of the committee are properly set out. The main board should consider how the delegation of duties to each committee works and whether that process is working well. Each committee should consider its own remit and whether it properly reflects the duties and responsibilities of that committee.

• Each committee should review how in practice it fulfils its duties and responsibilities at each stage during the financial calendar, for example how often it meets, and how it reports back to the board.

• The board should consider the composition of each committee, both in terms of compliance with the Combined Code but also in terms of whether the members reflect the right type of experience and skill. The composition of the committees may need to change from time to time in order to reinvigorate them.

All of these points apply with even more force to the audit committee, which has been the focus of the most attention in relation to Enron. It clearly has a crucial role to play in reviewing the company’s annual report and accounts and interim statements, the company’s relationship with its external auditors and overseeing the financial health of the company. There are a range of issues for both the board and the audit committee to review:

• The composition of the committee. The members must have sufficient accounting skill and knowledge to deal with complex accounting matters.

• The terms of reference of the audit committee should be reviewed and strengthened – for example, by reference to the ICAEW specimen terms.

• The audit committee should review what it does in practice at each stage of the financial year – the ICAEW audit committee guidance sets out suggestions for each key stage in the financial calendar; the sorts of questions that the audit committee should be asking and the information that the audit committee should be getting.

• The board should review how much time the audit committee devotes to its responsibilities and whether it has access to sufficient resources. Good practice in future is likely to require considerably more time to be allocated to meetings and reviewing documents than has been the case in the past, although the committee should always keep its overview function in mind and not get overwhelmed with detail.

• The flow of information between the audit committee and the board needs to be considered; how information is provided to the audit committee by the board and how the audit committee reports back to the full board. Ultimately the accounts are the responsibility of the whole board and the audit committee’s role does not change this.

• Just giving the audit committee the ability to contact the company’s auditors directly is not sufficient; there should be a specific arrangement for the audit committee to meet with the company’s auditors at key points in the financial timetable.

• The audit committee must be able to understand the accounts. It is not enough for the audit committee to be reassured by the finance director or auditor on complex technical or regulatory matters which the committee itself does not fully understand. If necessary, the audit committee should be offered the chance to have a “teach-in” by the auditors or others on any complex financial arrangements or auditing issues.

• The audit committee should ensure that key matters of judgement or contention between the company and its auditors (such as choices of accounting treatment) are brought to its attention, considered by the committee and reported on to the full board.

• The audit committee also needs to have access to information about issues raised by the press or analysts on the company’s accounts.

• The audit committee’s responsibilities include reviewing the appointment and performance of the company’s auditors and assessing conflict of interest and independence issues in relation to other work carried out by the same firm.

The focus of commentators in relation to the accounting issues arising from Enron has been on the need to move away from technical compliance with accounting standards to look at whether or not the accounts show a true and fair view. The board’s approach to accounting and financial information should be reviewed to ensure that this renewed emphasis on realism and clarity is properly emphasised in the review process:

• Can the accounts be readily understood by all board members?

• Do the accounts show a fair view overall, including clarity on difficult issues and highlighting of important matters?

• Is there too much emphasis on managing earnings to meet market expectations?

• Are the statements as to prospects for the following year realistic and clear?

The Combined Code requirement for the board to maintain a sound system of internal controls is supplemented by the guide published by the ICAEW on internal control which sets out the board’s responsibilities and the key elements of a proper system of internal controls. It is no answer to a claim that the directors have breached the Listing Rules for failing to issue a profits warning in a timely fashion, or that the directors have failed in their preparation of their accounts because they do not show a true and fair view, for the directors to say that they were unaware of particular problems or issues if actually they should have known about them. It is up to the board to ensure that the systems within the company generate the right flow of information up through the lines of responsibility to the board:

• The board needs to ensure that a proper review is undertaken of the internal controls each year by ensuring that there is a substantive investigation into the procedures and how they actually work in practice.

• There needs to be a clear allocation of responsibility for implementing any necessary changes.

• The board should regularly receive and review reports from management on internal control.

• Whistle blowing is an important element in managing internal control risk. What systems does the company have for allowing members of the staff to raise concerns that they may have about the practices being employed by their superiors and how it is publicised within the company?

Hindsight is a particular benefit enjoyed by regulators. Listed companies must have in place procedures to ensure that announcements required by Chapter 9 of the Listing Rules – particularly trading announcements – are made properly and promptly:

• How is market expectation (particularly analysts’ forecasts) monitored and brought to the attention of the board?

• What systems does the company have for reviewing its financial and trading position at board meetings and testing this against market expectations?

• What paper trail is created to show the process of that review and the justification for the decision taken not to make an announcement?

• Does the company regularly consult its professional advisers if an announcement may be required?

• What procedures does the company have in place for considering Chapter 9 announcements in the time between board meetings; and for convening board meetings at short notice if necessary to consider the need for a trading statement or other key announcement?

"© Herbert Smith 2002

For more information on this or other Herbert Smith publications, please email us."