The Higgs Report

The Higgs Report on Non-Executive Directors and the Smith Report on Audit Committees – substantial changes in corporate governance best practice

20 January 2003 saw the publication of both Derek Higgs’ "Review of the role and effectiveness of non-executive directors" and the Financial Reporting Council’s new guidance for audit committees, produced by a group chaired by Sir Robert Smith.

They constitute a significant overhaul of best practice in corporate governance. The new requirements, particularly those on the composition of boards and audit committees, will have a major impact on all UK listed companies.

The Higgs Report can be obtained from www.dti.gov.uk/cld/non_exec_review. The Higgs Report rejects the imposition of change by law or regulation and instead proposes a revised Combined Code and continuing with the "comply or explain" principle. The suggested new Code principles and provisions are discussed in the main text of the report (references in brackets below are to the relevant sections of the Higgs Report).

The FRC is inviting "fatal flaw" and drafting comments on the draft Code by 14 April, and will issue the final version to come into effect on 1 July. It is not yet clear whether there might be a transitional period for the "comply or explain" requirement for the new Code, or whether it will be in place in full for the 2004 annual report season.

The report also makes a number of best practice recommendations, which will not form part of the Code. These are collected together in Annex B.

Board balance

The biggest change is a new Combined Code provision that at least half of the members of the board, excluding the chairman, should be independent non-executive directors (9.5). This will involve a huge shake-up. Recent research by PIRC suggests that independent directors are in a majority on less than 20% of the boards it analysed. The report emphasises that the practical implications of this mean that it will take some time to achieve. However, listed companies will still have to explain whether they meet the board composition requirements and, if not, what steps they are taking to do so.

The other side of the coin is that it is not desirable to have a very small number of executive directors – that leads to a greater risk of distortion or withholding of information, or lack of balance in the management contribution to boardroom debate. The amended Code will therefore provide that there should be strong executive representation on the board (8.6).

Then the final part of the equation is that there is also to be a new Code provision to the effect that board sizes should not be so large as to become unwieldy (4.10) – so simply appointing a whole raft of new non-executives won’t work.

All of this means that there will be no sudden change and that companies will have to just gradually adjust the board balance over a number of years.

Role of the board

There was some speculation last year that the report might call for "two-tier" boards. In fact, it endorses the unitary board.

Higgs has, however, added a new Code provision that the non-executive directors should meet on their own at least once a year, and there should be a statement in the annual report on whether they have done so (8.8).

The Combined Code will contain an expanded statement on the role of the board (Chapter 4). This emphasises both its entrepreneurial role and its ethical responsibilities – to set the company’s values and standards and ensure that its bligations to shareholders and others are understood and met.

In addition, individual boards should publish in their annual report a description of how the board operates, including a statement of which decisions are taken by the board and which are delegated, and stating the number of meetings of the board and each board committee and attendance by individual directors (4.8).

Role of the chairman

The report suggests substantial changes in best practice in relation to the role and independence of the chairman. It takes a more robust stance than the existing Code on separating the roles of chairman and chief executive – a clear statement that the roles should be separated (5.3).

Augmenting this is a new Code provision that the division of responsibilities between the chairman and chief executive should be set out in writing and agreed by the board (5.5). The guidance on the chairman’s role and responsibilities (Annex D) will help in doing this.

The new Code will also say that a chief executive should not become chairman of the same company (5.7). This has previously been regarded as a tricky issue, but not one where there was a clear-cut view, and there are some recent high-profile examples of a chief executive moving on to become chairman. Finally, there is a new Code provision on the application of the independence criteria to the chairman. At the time of appointment the chairman should meet the test of independence (see below), but it is not appropriate or necessary for him to do so once he has been installed in his role (5.8).

The role of the non-executive director

A new provision in the Combined Code will give some guidance, for the first time, on the role of the non-executive director. This is fourfold: to challenge and contribute to strategy; to scrutinise the performance of management; to assess the accuracy of financial information and the robustness of risk management systems; and to determine levels of executive remuneration and play a key part in executive appointments, removals and succession planning (Chapter 6).

The report focuses on the behaviours and personal attributes that make a non-executive director effective. Critics of UK plc’s corporate governance have suggested that whilst corporate governance initiatives may prescribe structures and systems, truly effective protection lies in the calibre of the individuals involved. The report describes the relevant qualities: integrity and high ethical standards; sound judgement; the ability and willingness to challenge and probe; and strong interpersonal skills (Chapter 6, and the guidance for non-executive directors at Annex C).

Senior independent director

Higgs endorses the appointment of a senior independent director, which was one of the more controversial innovations in the original Combined Code.

What is new is the proposed Code provision which will say that the main role of the appointee will be to act as a separate channel for shareholders (7.5). The senior independent director should be available to shareholders who have concerns that have not been resolved through contact with the chairman or chief executive, or which are inappropriate to raise with them. Initial reactions have been that this could lead to boardroom splits; only time will tell whether that will be the case.

Another new Code provision will make it the senior independent director’s responsibility to attend "sufficient of the regular meetings of management with a range of major shareholders to develop a balanced understanding of the themes, issues and concerns of shareholders" (15.15).

Independence

Whilst focusing on the technical concept of "independence", the report does point out that all non-executive directors and indeed all executive directors need to be independent in the sense of being independent of mind and willing and able to question, challenge and speak up.

For the first time, there will be some guidance in the Combined Code itself on the meaning of "independence" in the stricter sense, as it is to be applied to independent non-executive directors (see inset box for the new definition). There are currently over a dozen such definitions in the UK, despite the attempts of the ABI and NAPF who published a joint statement of guidance in 1999 which they hoped would be definitive. It will be interesting to see whether the various shareholder bodies do indeed drop or amend their own criteria for assessing independence.

Recruitment and appointment

A key aspect is the report’s focus on the importance of the nomination committee, which has tended not to attract as much attention as the audit and remuneration committees.

Higgs found that high levels of informality still surround the process of appointing non-executive directors. Almost half of the non-executive directors surveyed were recruited to their role through personal contacts or friendships, despite the existing requirement in the Combined Code that non-executive directors should be appointed pursuant to a formal and transparent procedure. This will support the arguments of those who oppose the voluntary "comply or explain" approach as ineffective.

New Code provisions for strengthening the role of the nomination committee (10.9) include:

• An express recommendation that all listed companies should have one (hitherto "small" boards have been excused).

• A requirement that there should be a majority of independent non-executive directors (previously they were not required to be independent) and that it should be chaired by an independent non-executive director (previously, the chairman of the board or a non-executive director).

• The committee’s terms of reference should be made public.

• Before making a particular appointment, the committee should analyse the skills, knowledge and experience of the existing directors and in the light of this, prepare a description of the role and capabilities required for the new appointment.

• There should be a statement on the committee’s activities in the annual report; if external advice or open advertising has not been used, an explanation should be given; the number of committee meetings and individual attendances over the period should be stated.

• New non-executives should receive a letter of appointment setting out what is expected in terms of time commitments, committee membership and involvement outside board meetings (a specimen letter is provided in Annex H).

• When a non-executive appointment is put to a shareholder vote, the board should explain why they believe the individual should be appointed and how they meet the requirements of the role as described by Higgs.

A non-Code recommendation is that potential new non-executive directors should conduct due diligence on the board and the company to satisfy themselves that they have the right knowledge, skills and experience, and adequate time, to make a contribution to the board. Annex G sets out guidance for directors on pre-appointment due diligence. The revised Code will also contain a provision setting out for the first time the nomination committee’s role in orderly succession planning (10.13). And, although it is not in the Code, Higgs recommends that chairmen and chief executives should implement programmes to train and develop senior employees for future director roles (10.14).

Time commitments and limits on directorships held

The consultation responses indicated that there was widespread concern that non-executive directors devote insufficient time to their roles. The report suggests that greater clarity in the time commitments expected of directors would be useful. The new Code requirements will be:

• Non-executive directors must disclose to the chairman the nature and extent of their other appointments and confirm that they will have the time required for their role (12.13).

• The nomination committee should annually review the time required and use performance evaluation to assess whether the non-executive director is spending enough time on their duties (12.14).

• If a non-executive is offered appointments elsewhere, the chairman should be informed before any new appointment is accepted and the board should subsequently be informed (12.14).

• A full time executive director should not take on more than one non-executive directorship, nor become chairman, of a major company (that is, one which is or is likely to be a FTSE 100 company), and no individual should chair the board of more than one major company (12.19). Apart from this there is no limit per se on the number of non-executive directorships an individual can hold (12.16).

Nominating and appointing the chairman

There is some new non-Code guidance on nominating and appointing the chairman (10.34). The senior independent director, or deputy chairman if independent, should lead the process; the skills and expertise required should be identified and a job specification drawn up; and a shortlist of candidates should be considered, rather than possible individuals being considered in turn (10.35).

Widening the pool of non-executive directors

The report contains some practical suggestions for widening the pool of potential non-executive directors, such as considering individuals working in the charitable and public sectors who have developed strong commercial understanding (Chapter 10). These recommendations are not in the revised Code itself, but Sir Derek pulls no punches in his Introduction: "People are the key. Critical to improving the effectiveness of non-executive directors is raising the quality of appointees. The evidence collected for the Review shows that the current population of non-executive directors is narrowly drawn."

Higgs notes with approval that a new body made up of business leaders and others will be set up to help unearth candidates from the non-commercial sector who could have the right attributes. This group will report to the DTI in May.

Induction and Training for Directors

The revised Code will contain new provisions on induction for non-executive directors (11.1). It will be the chairman’s responsibility to ensure that new directors receive a comprehensive, formal and tailored induction on joining the board, which should include meetings with major investors.

The chairman will also be responsible for ensuring that the directors continually update their skills and knowledge (new Code provision A.5.7). The report has some thoughts on the conundrum of formal training for directors. Surveys of directors generally find that they would welcome more training, yet formal training programmes offered by business schools and other providers have a poor take-up. This is at least partly a reflection on the quality of the training that is on offer. The recommendation is that there should be a step change in training and development provision so that it is suited to the needs of boards (11.17).

Evaluation of directors

There are to be new Code provisions on performance evaluation. Boards will be required to evaluate their performance at least once a year (11.22).

Evaluation should cover the board, the committees and the individual directors. The chairman should act on the results of the evaluation, if necessary by appointing new members or seeking the resignations of existing directors.

The annual report should state whether performance evaluation is taking place and how it is conducted. This will be a significant change for many listed companies, as recent research by KPMG suggests that more than half of non-executive directors do not undergo formal performance evaluation, and of those who are assessed, less than a quarter are assessed annually.

The Company Secretary

The Code will now provide expressly that the company secretary has an important part to play in ensuring that adequate information, of the right kind, gets into the hands of the non-executives: "The chairman, supported by the company secretary, should assess what information is required. The executive directors should assemble it and be ready to validate its accuracy, reliability and compliance with laws and standards" (11.26).

The company secretary has overall responsibility to the board on corporate governance, and a new Code provision says he or she should be accountable to the board through the chairman on all governance matters (11.31). Impartiality and integrity are key. The report recommends (although it would not be a Code requirement) that larger companies, who are able to do so, should separate the roles of company secretary and finance director, and that smaller companies should build "Chinese walls" between the roles, so that information received in one capacity is not used for other purposes (11.33).

It is good practice (although not a new Code provision) for the company secretary or their designee to be secretary to all board committees (11.30).

Tenure of non-executive directors

The report says that an initial appointment for a non-executive director should not be less than three years (subject to satisfactory performance) and that it is reasonable to expect most non-executive directors to serve a second three year term (12.3). However, new Code provisions will make it clear that two three-year terms should be regarded as the norm and if, exceptionally, the board considers that there is value in a non-executive director serving longer, the reasons for it must be explained for shareholders (12.5). After nine years, non-executives should be subject to annual re-election (12.6).

Higgs considers that whilst a standard term of tenure for chairmen would not be appropriate, it is useful to appoint the chairman on three-year terms which may be renewed where appropriate.

Remuneration

The report supports greater transparency in the make-up of non-executive directors’ remuneration, and there is a non-Code recommendation that it should be clearly built up from an annual fee, meeting attendance fees (including committee meetings) and an additional fee for chairing committees or role as an independent director.

The report suggests that actual levels of remuneration are pretty much in line with expectations at larger companies, but that a modest increase at smaller listed companies might be merited. It warns against high levels of remuneration: "the risk of high levels of remuneration (or a large shareholding) prejudicing independence of thought is real and should be avoided."

Higgs articulates existing best practice in stipulating that non-executive directors should not hold options over the shares in their company (12.27), and this is a suggested new Code provision (applicable to non-executives generally, not just those who are independent). However, he believes there is merit in giving non-executive directors the opportunity to take part of their remuneration in shares (12.26).

There is a non-Code recommendation that companies should encourage executive directors and senior executives to take on non-executive posts elsewhere. Where an executive director is released to do so, the company should state in the remuneration policy report whether or not the director will retain his non-executive director fees and if so, the amount (the NAPF recommends that retention should not be permitted).

Resignation

There is an interesting discussion of the non-executive director’s "ultimate sanction" – resignation. Higgs’ view is that resignation should be regarded very much as a last resort, only when all other efforts to resolve the problems have failed, and points out that non-executive directors may be constrained by their fiduciary duties from resigning. A new Code provision says that in circumstances where non-executive directors have real concerns about the way the company is run or about a proposed course of action, they should raise them with the chairman and other directors. The Code will also say that they should ensure, as a matter of course, that their concerns are recorded in the minutes if they cannot be resolved (12.31).

The Code will say that if a non-executive director feels that resignation is the only option, a written statement should be provided to the chairman, for circulation to the board, setting out the circumstances (12.32). Non-executives should also explain their reasons for resigning when they leave in other circumstances.

Audit and remuneration committees

As well as having enough independent non-executive directors on the board, companies will have to comply with a new Code provision preventing any one individual from being on all three principal board committees at the same time (unless the board is small) (13.2).

Please see the section below on the Smith Report for a summary of the new recommendation on audit committees.

As now, the remuneration committee should consist exclusively of independent directors (13.8). It should have at least three members. There is a word of caution about the use of remuneration consultants: "compensation consultants were often perceived to be too close to executive management and too ready to encourage companies to position their remuneration policy in the "upper quartile" of their peer group comparators. Such a policy can have a one way ratchet effect which is undesirable for individual companies and inflationary and self-defeating in the market place."

The report echoes the recent ABI and NAPF statement on executive contracts and severance (published in December 2002), recommending that the remuneration and nomination committees work closely together to ensure that incentives are appropriately structured and that terms in case of severance are carefully considered (13.10). A new Code provision states that the remuneration committee should consider the advantages of providing explicitly in the initial contract for compensation commitments on severance except in the case of removal for misconduct, bearing in mind that such provisions should not have the effect of rewarding poor performance.

The Code will provide that the remuneration committee should have responsibility for setting remuneration for all executive directors and the chairman, and should set the level and structure of remuneration for senior executives (13.12), and that it should make its terms of reference publicly available (13.11). The Code will also provide that if executive directors or senior managers advise or support the committee, this role should be clearly separated from their role within the business.

A summary of the principal duties of the remuneration committee is set out in Annex E of the Report.

Liability of non-executive directors

The report welcomes the proposals of the Company Law Review for a codification of directors’ duties. In addition, it suggests some guidance aimed at non-executive directors in particular, which is to be annexed to the revised Combined Code. This would make it clear that whilst non-executive directors are under the same legal duties as executive directors, the knowledge and experience of a company’s affairs that could reasonably be expected of a non-executive director will generally be less than for an executive director. This may be relevant in assessing the duty of care, skill and diligence that the non-executive director may be expected to exercise.

The report notes that a director who is sued may apply to the Court for relief under Section 727 of the Companies Act 1985, and that it would be helpful for directors if such applications were dealt with promptly. Higgs recommends that the Lord Chancellor’s Department considers steps to promote active case management in cases applying to directors (14.11).

Insurance and indemnification

The report also considers the difficult issues surrounding insurance and indemnification of directors.

On indemnification, it recommends that the Government should go further than it is already proposing to do under the Company Law Review, and change the law so that a company can indemnify a director in advance against the reasonable cost of defending proceedings from the company itself, without trying to establish in advance the prospects of success of the case (14.16). It is difficult to see how this would work in practice, even if the Government does amend the law. If the disinterested members of the board have already decided that it is in the company’s best interests to bring proceedings against a director, how could they then decide that it is also in the best interests of the company to indemnify that director against his legal expenses? The only practical answer would seem to be insurance which covered the directors’ legal expenses, but the insurance industry has responded to the Higgs proposal by saying that such a change could result in a further massive increase in insurance premiums.

The report recommends a new Code provision to the effect that companies should arrange appropriate insurance cover for their directors. There is also a non-Code recommendation that companies supply details of their D&O cover to potential non-executive directors before they are appointed.

Relationships with shareholders

We have already noted that the senior independent director will have an enhanced role in meeting with major shareholders. Chapter 15 of the report also makes several other suggestions aimed at strengthening relationships. There is a new Code provision to the effect that non-executive directors should be able to attend meetings with major investors from time to time, and should expect to do so if requested by major investors (15.16).

As noted above, non-executive directors should meet with major shareholders as part of the induction process (15.17). It is also suggested that the company secretary could act as a conduit between major shareholders and non-executive directors (15.19).

The report supports the recent efforts of the Institutional Shareholders Committee to promote more active shareholder engagement (see our November 2002 briefing "Institutional shareholder activism: a sea change?" available via the contact details at the end of this bulletin) and endorses them in a new Code provision (15.24). The Code will also recommend that institutional shareholders should be expected to attend the AGM where practicable (15.25).

Smaller listed companies

These are defined as those outside the FTSE 350.

The Report says that the Combined Code should apply in full to smaller listed companies. The only exception is the recommendation that no one individual should sit on all three of the principal board committees. The report recognises however that it may take more time for smaller listed companies to comply and that some of the Code’s provisions may be less relevant or manageable for smaller companies. But the nature of the Code is such that companies can explain to shareholders where there is good reason for this, or for complying in a different way.

A committee chaired by Sir Robert Smith, which also reported on 20 January, has reviewed and substantially expanded the Combined Code guidance in relation to audit committees. The report is available at http://www.frc.org.uk/publications/content/ ACReport.pdf.

The Smith Committee has liaised with Higgs to ensure that their approaches are in line. As with Higgs, Smith does not suggest any new legislation and instead proposes changes to the Combined Code. The new draft Combined Code in the Higgs Report incorporates the Smith proposals.

The changes to the Code will, as in the case of the Higgs Report proposals, come into force on 1 July 2003.

The introduction to the Guidance states that, whatever specific arrangements are put in place for an audit committee, these will not be effective unless there is mutual respect and open communication between the audit committee, the rest of the board and non-board executives. While it encourages the audit committee to take an independent stance from the executive function, it supports the existing UK unitary board structure, stating that its recommendations do not undermine that model.

The following recommendations are included in the new Combined Code, either directly or by cross-reference to the "black letter" requirements of the Smith Guidance, which is to be annexed to the Code. (Those parts of the Guidance that are "black letter", and therefore are stated to be essential, are marked * in the discussions below).

There should be at least three members of the audit committee, all independent non-executive directors*. The chairman of the company should not be a member*. Appointment (on recommendation of the nomination committee) should be for up to three years, with a maximum of three terms in total (i.e. nine years), as long as members continue to be independent.

Meetings

Audit committee meetings should be held at key stages in the company reporting cycle (usually at least three a year), but there is an emphasis on continuing communication outside formal meetings.

Only audit committee members should be entitled to attend meetings*; non-members will attend by invitation. A meeting with the external and internal auditors should take place at least once a year without management.

Resources and remuneration

The audit committee should be provided with sufficient resources to undertake its work*, for instance the services of the company secretary. This includes funds to take independent external advice, for example from lawyers or accountants.

The audit committee members, particularly the chairman, should be remunerated to recompense them for the additional work they are expected to undertake.

Skills, experience and training

At least one member of the audit committee should have ‘significant, recent and relevant financial experience’, preferably with a professional accounting qualification*. The report recognises that this will not always be necessary for smaller companies with straightforward operating and reporting issues.

A degree of financial literacy is also recommended for all members. To this end, training should be provided to audit committee members, both on joining and on an ongoing basis, for example on the company’s regulatory framework, financial reporting and company law issues, and the role of internal and external audit and risk management.

Terms of reference and relationship with the board

The board should provide written terms of reference for the audit committee*, tailored to the needs of the company (a basic example is given in Appendix I of the report). Both the audit committee and the board should review the effectiveness of the audit committee annually.

Where there is a disagreement between the board and the audit committee that cannot be resolved, the audit committee should have the right to report the issue to shareholders as part of the report on its activities in the directors’ report. This is controversial in light of the Smith Committee’s expressed support for the unitary board.

Financial reporting

One of the audit committee’s central roles is oversight of financial reporting, including review of significant issues and judgements made and clarity and completeness of disclosure*. There is a specific recommendation to report any dissatisfaction to the board on any financial reporting matters, including market announcements*.