UK: Investment Funds

Last Updated: 12 March 2003

Investment Companies: Recent Developments in Corporate Governance

Recent months have seen significant developments in relation to corporate governance issues affecting investment companies. January 2003 saw the publication of the Higgs Report on non-executive directors. This was swiftly followed by the publication by the Association of Investment Trust Companies of their Draft Code of Corporate Governance, itself drawing on the provisions set out in the Higgs Report. In addition the Financial Services Authority, prompted by the recent issues surrounding split-capital trusts, has published consultation paper 164 (CP164) which contains among other things additional proposals addressing the relationship between investment companies and their managers.

This briefing seeks to highlight a number of areas particularly pertinent to investment companies where either the provisions of the Higgs Report do not reflect current practice in the industry or where apparent tensions exist between the Higgs Report, the AITC Draft Code and/or CP164.

Manager Representation at Board Level

While the Higgs Report stresses the importance of independent non-executive directors, it also makes quite clear that it considers it desirable that there should be strong executive representation on boards. In the case of investment companies, the equivalent of an executive representative would normally be taken to be a representative of the investment manager. By contrast, CP164 proposes a new listing rule which would have the effect of precluding a director or employee of, or a professional adviser to, the investment manager from being appointed to the board of an investment company. Despite the perceived determination of the FSA in relation to this issue, we consider this proposal to be wrong in principle and in conflict with the wider aims expressed in the Higgs Report. It also clashes with the position suggested by the AITC Draft Code, which would permit a manager appointee to sit on the Board. CP164 seems to place too great an emphasis on the possibility of undue influence by a manager appointee and insufficient weight on the benefits of having a director with real executive responsibility, duly appointed, as a member of the board and required to act in the best interests of the investment company’s shareholders. In our view, a properly operating board of independent directors with a suitably constituted management engagement committee tasked with reviewing the company’s arrangements with its investment manager (which would exclude any investment manager appointee) should be capable of avoiding undue influence. We also consider that a manager appointed director can increase the overall quality and efficacy of the decision making process and enhance the way in which information passes between manager and board by maintaining an open dialogue between each constituency.

Board Composition

The Higgs Report lays emphasis on the fact that good corporate governance is not so much a question of prescribed structures and systems but instead relies on the calibre of the individuals involved. It has always been the case under the Listing Rules that the majority of the board should be independent of the manager and the AITC Draft Code supports this position. However, CP164 goes much further by suggesting that any director of an investment company who is also a director of another investment company managed by the same investment manager will not be regarded as independent.

By contrast, the AITC Draft Code recommends that the chairman of the board of company A should only serve on another board of another investment company managed by the same manager where the other independent directors of company A are prepared to make a specific appraisal of independence, which is disclosed in the annual report. Furthermore, the AITC Draft Code seeks to extend this concept of "affirmed independence" to any director sitting on multiple boards of companies with the same investment manager, again with disclosure in the annual report. Neither of these provisions meets the requirements of CP164 and it remains to be seen how the FSA will address this point in its final rules. Issues relating to the composition of the management engagement committee will need to be considered in this light.

It does, however, seem to us that in the current climate, where it may become increasingly difficult to persuade high calibre individuals to act as non-executive directors of investment companies, these restrictions may simply act to limit further the pool of available talent from which non-executive directors can be drawn by investment companies seeking to establish strong and knowledgeable boards of independent non-executive directors. In addition, we consider that in certain circumstances, for example where a manager is responsible for a number of investment companies with very similar structures and/or mandates, there could be a real advantage in having a common chairman who is familiar with the issues pertinent to that type of investment company. This is particularly relevant for offshore domiciled funds where the pool of suitably qualified candidates is even smaller.

Nominations Process

The Higgs Report has placed great emphasis on the nominations process responsible for selecting and appointing new non-executive directors. Investment companies which do not currently have a formal nominations committee, or where such activity is undertaken by the full board, will need to review their procedures in the light of both the Higgs Report and the AITC’s Draft Code. The emphasis now seems to be strongly on the board giving far greater disclosure on the process by which non-executive directors are to be appointed and making it more formal and objective.

Length of Tenure

There appears to be some divergence of views in this regard. The Higgs Report suggests that directors with more than 10 years service will no longer be regarded as independent. Indeed, it explicitly suggests that two 3-year terms should be regarded as the norm for non-executive directors unless, exceptionally, the board considers there is value in a non-executive director serving for a longer period, where such reasons must be explained to shareholders. In any event, the Higgs Report suggested that after 9 years service non-executives should be subject to annual re-election.

The AITC, by contrast, suggests that lengthy service on a board does not necessarily compromise independence and may indeed have advantages in terms of in-depth knowledge gained through experience. Accordingly, the AITC does not recommend that long-serving directors be prevented from forming part of an independent majority but rather suggests that directors be appointed for a fixed term of no more than 3 years and that subsequent re-nominations should not be assumed but should be based on disclosed procedures such that shareholders can be confident that re-appointment is the result of serious consideration.


One significant issue facing all boards at present is the tightening of the market for Directors & Officers insurance resulting in substantially lower cover being available at a substantially higher premium. The Higgs Report suggests that company law should be amended to allow companies to indemnify their directors in advance against the reasonable costs of such directors being required to defend proceedings brought by the company itself, without first having to establish the prospects of success in a case. While this could be a significant step forward and remove most of the concerns concerning the lack of D&O insurance, it is not clear yet how this proposal could be workable in practice and it remains to be seen whether the Government will adopt this proposal.

In addition, the Higgs Report has welcomed the proposed codification of directors’ duties but has suggested that further guidance for non-executive directors would be valuable. This would make it clear that while non-executive directors are under the same basic legal duties as executive directors, the knowledge and experience of the company’s affairs that could reasonably be expected of them would generally be less than that of an executive director. It is not clear how this codification would translate to investment companies where there are no executive directors but we would surmise that any codification in this area would be helpful in establishing exactly what non-executive directors of investment companies are required to do to satisfy their duties.


The points set out above represent the most important areas where the Higgs Report, the AITC Draft Code and CP164 diverge or where significant changes may be required to existing practice. There are clearly a substantial number of points of detail coming out of the Higgs Report and the AITC Draft Code in particular which will require further attention. Following the end of the consultation period on CP164 in mid-April, it should be possible to get a better feel for the position the FSA will ultimately take. Each of these documents will require boards of investment companies to think carefully about their existing corporate governance structure, board composition and the perceived role for their directors going forward.

By Nigel Farr & Scott Cochrane

© Herbert Smith March 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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

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