In April 2002 the Government commissioned Derek Higgs to undertake an independent review of the role and effectiveness of nonexecutive directors. It was published on Monday 20 January 2003 at the same time as the Financial Reporting Council’s report on Developing the Guidance on Audit Committees (the Smith Report).
The review was initiated as part of a systematic re-appraisal of the adequacy of corporate governance arrangements in the wake of recent corporate failures, most notably in the United States. It follows the existing framework of corporate governance which began with the publication of the Cadbury report followed by the Greenbury and Hampel reports, all of which were combined to form the Combined Code.
Higgs’ view is that tighter corporate governance is preferable to legislative intervention which is the alternative that the United States has chosen in passing the Sarbanes-Oxley Act. He makes recommendations to build on the existing corporate governance framework (most notably the Combined Code), and what he describes as the ‘comply or explain’ nature of the Combined Code.
The review sets out significant changes to the Combined Code and also makes a number of non Code recommendations. It concentrates on corporate governance arrangements for UK listed companies. However, many of the Combined Code’s principles and guidelines are adopted by AIM companies (and, in some cases, large private companies). As a result, Higgs recognises that a number of his recommendations may be relevant to AIM and other companies and organisations.
THE PRINCIPAL RECOMMENDATIONS
Half of the Board, excluding the chairman, should be "independent" non-executive directors. The current position under the Combined Code recommends that not less than one third of the directors should be non-executive. The issue of independence is at the heart of any debate on nonexecutives. It is suggested that a definition of "independent" be included in the Combined Code. A non-executive director is to be considered independent when the Board determines he is independent in character and judgment and where there are no relationships or circumstances which might affect that director’s judgement. A director will not be independent if he:
- has been an employee of the company within the last five years;
- has had a material business relationship with the company within the last three years;
- receives remuneration from the company beyond the non-executive director’s fee;
- has close family ties or cross-directorships;
- is a significant shareholder or has served on the Board for more than ten years.
Those non-executive directors deemed to be independent would have to be listed as independent by the Board in its annual report.
2. ROLE OF THE NON-EXECUTIVE DIRECTOR
The Higgs review does not propose to introduce a legal distinction between the duties and responsibilities of executive directors and non-executive directors; however, a clarification of the role of a nonexecutive director was viewed as being useful and it has therefore been proposed that a description of the role be included in the Combined Code.
The role is defined under the following headings: (i) strategy (to constructively challenge and contribute to the development of a company’s strategy), (ii) performance (to scrutinise and report on the performance of management), (iii) risk (to be satisfied with the reliability of financial information and the adequacy of financial controls and systems) and (iv) people (to have responsibility for determining appropriate levels of remuneration for executive directors and a prime role in the appointment, remuneration and removal of management and in succession planning).
Under the proposals, non-executive directors would be required to meet as a group, on their own, at least once a year and the annual report should contain a statement as to whether or not this has happened.
The review further suggests that, prior to appointment, potential non-executive directors should carry out due diligence on the Board and company to satisfy themselves that they have the knowledge, experience and time to make a positive contribution to the Board. A suggested checklist has been proposed so that nonexecutives can assess this.
3. SENIOR INDEPENDENT DIRECTOR
The review proposes that each company should have a senior independent director (endorsing a provision already in the Combined Code). He must meet the independence test and be a non-executive who is to be available to shareholders if they have any concerns that are not resolved through the normal channels of contact with the chairman and/or chief executive.
4. RECRUITMENT AND APPOINTMENT
There should be a nomination committee. By comparison, the current position under the Combined Code is that unless a board is small, there should be a nomination committee. Under the Combined Code the nomination committee should be made up of a majority of non-executive directors but the review refines this by requiring the majority to be made up of "independent" non-executive directors. Further, the committee should be chaired by an "independent" non-executive director.
As far as the appointment of non-executive directors is concerned, the review emphasises the desirability of using a wider pool from which to choose non-executive directors. It coyly notes that "a high level of informality" surrounds the process of appointing non-executive directors at present. This was widely criticised in responses to the consultation and Higgs notes that it can "lead to an overly familiar atmosphere in the boardroom". To address this, the review suggests that a greater use of formal recruitment processes should be employed and that the nomination committee should consider the skills, knowledge, experience of the candidate and role which is required of him before making appointment recommendations to the Board. Importantly, the Board should also set out to shareholders why an individual should be appointed as a nonexecutive director.
It is suggested that non-executive directors should always be appointed on written appointment terms (not a novel suggestion) and a specimen letter of appointment is appended to the review. A non-executive director should also be obliged to confirm that he has time available to undertake his role. Lack of time commitment was one of the main criticisms made of non-executive directors.
One area which has caused controversy is the recommendation that a limit be placed on how many non-executive appointments an executive director can hold. The report states that a full time executive director should not take on more than one nonexecutive directorship nor become chairman of a major company (defined as a FTSE 100 company). Furthermore, no individual should be chairman of more than one major company. It is suggested that this best practice be incorporated in the Combined Code. Significantly, the review does not limit the number of non-executive directorships that an individual (as opposed to a full executive director) may hold over all.
The report does not consider this area in great detail. Payment on the basis of fixed fees (i.e. annual fees and meeting attendance fees etc) is endorsed, as is part payment in shares in lieu of cash provided that the non-executive director’s shareholding does not represent a large proportion of his wealth. Granting options to non-executive directors, however, is disapproved of due to the "risk of undesirable focus on share price rather than the underlying company performance".
6. INDUCTION AND PROFESSIONAL DEVELOPMENT
This is a new concept but is part of the overall theme that non-executive directors should be appointed on a more "scientific" basis and non-executive directorships should not be undertaken lightly. The suggestion is that all new non-executive directors should undergo an induction programme and a suggested checklist is appended to the review.
The performance of the Board, its committees and each individual member should be evaluated once a year and the process should be reported on in a company’s annual report.
The view is that although a non-executive’s relevant skills and experience will have already been tested upon appointment, it is important that the knowledge and skills of non-executive directors are extended and "refreshed". It is suggested that updates on legal, regulatory and other obligations would be helpful as well as "revisiting the effective behaviour of a director such as influencing skills, conflict resolution, chairing skills and board dynamics".
The role and responsibilities of the chairman are considered in some detail, the salient point made being the endorsement of the separation of the roles of chairman and chief executive, as well as the corresponding suggested changes to the Combined Code.
The response from major companies who are likely to be affected by the proposals has not been altogether favourable. It has been estimated that companies would collectively have to find up to 1,000 new non-executives to comply with the recommendations, which is too demanding to meet. Chairman, particularly, are unhappy with an enhanced role for the senior independent director in relation to dealings with major shareholders.
However, whilst many of these proposals have been seen before in some guise or other, there is a chance of greater universal acceptance amongst listed companies if they are incorporated into the Combined Code (which could be as soon as July of this year), especially given that in many instances, non compliance is a disclosure issue in a company’s annual report. One less happy consequence is that we may see a marked difference in the level of detail and prescriptiveness creeping into the Combined Code. Until now, it has been refreshingly short and succinct.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.