ACCA P1 Governance, Risk and Ethics - 2011 - Study text - Emile Woolf Publishing
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Paper P1: Governance, risk and ethics
64 © Emile Woolf Publishing Limited
Only non-executive directors can be independent. However, not all NEDs are
independent. A NED is not independent when there are relationships with the
company or circumstances that would be likely to affect the director’s judgement.
Independent directors are defined in various codes and principles of corporate
governance. The UK Combined Code states that in most circumstances, a director is
not independent when he or she:
has been an employee of the company within the past five years
has (or has had within the previous three years) a material business relationship
with the company, either personally or as a partner, shareholder, director or
senior employee of another entity
receives remuneration in addition to a fee as non-executive director, participates
in the company’s share incentive scheme or a performance-related pay scheme,
or is a member of the company’s pension scheme
has close family ties with a director, senior employee or professional adviser of
the company
has significant links with other directors through involvement in other
companies or entities
represents a major shareholder
has served on the board for more than nine years since the date of his/her
election as director.
(The ‘nine year rule’ on independence for NEDs has been slightly controversial, and
some UK listed companies have NEDs who have been in office for over nine years,
but who, according to the company, remain independent.)
Definitions of ‘independent director’ vary between countries and codes. In
Singapore, for example, the definition is less strict than in the UK. Its Code of
Corporate Governance states that examples of relationships where a director is not
deemed to be independent are as follows:
Where the director is employed by the company (or any related company) or has
been employed by the company at any time during the past three years.
A close family relative of an individual who is a senior employee of the
company, or who has been a senior employee at any time during the past three
years.
A director receiving remuneration from the company in the current or previous
financial year, in addition to his fee as non-executive director.
A director who has (or has had in the current or previous financial year) a
material business relationship with the company, either personally or through a
close family member, or as a partner, shareholder, director or senior employee of
another for-profit entity.
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2.5 Board balance and independent directors
The status of directors as independent or ‘not independent’ is significant for
companies that are required to comply with a code of corporate governance.
A general principle of good corporate governance is that there should be a suitable
balance of individuals on the board.
A board should consist of directors with a suitable range of skills, experience and
expertise. However, there should also be a ‘balance of power’ on the board, so that
no individual or small group of individuals can dominate decision-making by the
board.
Experience has shown that in the past, a feature of many large public companies
that have collapsed dramatically has been a domination of the board’s decision-
making by an individual or a small group of individuals. In the UK, for example, a
link between bad corporate governance and domination by a powerful individual
was evident in the cases of the Maxwell Communications Corporation (headed by
Robert Maxwell) and Polly Peck International (headed by Asil Nadir). Both these
companies collapsed unexpectedly in the early 1990s.
Example
The case of Robert Maxwell is notorious in UK corporate history. During the 1980s,
Maxwell built up a major publishing group, which included Mirror Group
Newspapers, the US publisher Macmillan and the New York Daily News. Mirror
Group Newspapers became a listed UK company, but the other companies in the
group remained privately-owned. Maxwell was reported to have been a tyrannical
leader of the company, who dominated the board of directors of the companies
within the group.
In November 1991, Mr Maxwell died in mysterious circumstances, drowning during
a cruise off the Canary Islands. After his death, it was found that he had
misappropriated about £900 million from the pension funds of his companies, using
the money to fund business expansion and to support group companies that were in
financial difficulty. In 1992, the Maxwell companies in the UK and US were forced
to file for bankruptcy/insolvency. A subsequent investigation found that ‘there
were no proper corporate or financial controls’ to prevent Maxwell from doing what
he had done.
This case was one of several corporate collapses that led to recognition of the need
for a balance of power on the boards of major companies.
Definition of a suitable board balance
The UK Combined Code states: ‘The board should include a balance of executive
and non-executive directors (and in particular independent non-executive directors)
such that no individual or small group of individuals can dominate the board’s
decision-taking.’
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It goes on to state that: ‘To ensure that power and information are not concentrated
in one or two individuals, there should be a strong presence on the board of both
executive and non-executive directors.’
The Combined Code then goes on to specify that:
Except for smaller listed companies, at least 50% of the board, excluding the
chairman, should consist of independent non-executive directors. This
requirement applies to listed companies in the FTSE 350 Index. (It is usual for
the chairman of a UK listed company to be independent.)
In smaller listed companies, there should be at least two independent non-
executive directors.
Codes of corporate governance in other countries differ. For example, the Singapore
Code of Corporate Governance states that independent directors should make up at
least one-third of the board.
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The roles of chairman, chief executive officer and NEDs
Separation of the roles of chairman and chief executive officer
Role of the CEO
Role of the board chairman
The role of non-executive directors
The appointment of non-executive directors
Criticisms of NEDs
3 The roles of chairman, chief executive officer and
NEDs
3.1 Separation of the roles of chairman and chief executive officer
The two most powerful positions on the board of directors are those of chairman
and chief executive officer (CEO).
To avoid the risk that one individual might dominate decision-making by the board,
the UK Combined Code states that:
The roles of chairman and chief executive officer should not be held by the same
person.
In addition, a CEO should not go on to be the chairman of the company.
The Combined Code states as a principle that ‘no one individual should have
unfettered powers of decision’. For the same reason, the Singapore Code of
Corporate Governance includes a provision that the chairman and CEO should ‘in
principle’ be different individuals. Obviously, however, there should be a good
working relationship between the chairman and the CEO.
In the UK, it is now unusual for the same person to be both chairman and CEO of a
listed company. However, the provision in the Code that a CEO should not go on to
become the company chairman has caused some controversy. The idea behind the
provision in the Code is that a CEO who ‘steps up’ to become the company
chairman might seek to dominate or influence his successor as CEO. However, some
companies have argued that when a CEO decides that he wants to do something
different, a company might be able to retain his experience and knowledge of the
company’s affairs by offering him a part-time role as chairman.
Example: Marks and Spencer
In 2004, Marks and Spencer successfully resisted a takeover bid for the company
from Philip Green. The successful takeover defence was organised by the company’s
new chairman (Paul Myners) and new chief executive (Stuart Rose).
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During 2005 the senior independent director (a non-executive director) argued that
the chairman and the chief executive were too close to each other, and that there
was insufficient independence between them. After strong pressure from Lomax,
Myners agreed to step down as chairman and his successor Sir Terry Burns was
appointed (initially as deputy chairman in 2005) to take his place.
Critics argued that this change had broken up a highly successful working
relationship between the company’s chairman and CEO.
3.2 Role of the CEO
The CEO is responsible for the executive management of the company’s operations.
He or she is the leader of the management team, and all senior executive managers
report to the CEO. If there is an executive management committee for the company,
the CEO should be the chairman of this committee.
Other executive directors may sit on the board of directors, the CEO reports to the
board on the activities of the entire management team, and is answerable to the
board for the company’s operational performance.
3.3 Role of the board chairman
In many public companies, the role of chairman is part-time. The UK Combined
Code states that on appointment to the position, the chairman should be
independent. If companies comply with the Combined Code, a chairman will
therefore be both independent and non-executive.
The board chairman, or company chairman, is the leader of the board of directors.
He or she is responsible for managing the board. Whereas codes of corporate
governance have little to say about the responsibilities of the CEO, they have quite a
lot to say about the role and functions of the chairman.
The UK Combined Code identifies the following responsibilities for the board
chairman:
As leader of the board, the chairman is responsible for its effectiveness in
performing all aspects of its role. The chairman also sets the agenda for board
discussions.
The chairman is responsible for ensuring that all directors receive ‘accurate,
timely and clear information’. This is particularly important for non-executive
directors, who rely for most of their information about the company on what the
chairman provides. If they are not well-informed, NEDs are unable to contribute
effectively to the discussions of the board or to decision-making.
The chairman is also responsible for communications between the company and
its shareholders.
The chairman is responsible for ensuring that the NEDs contribute effectively to
the work of the board, and for ensuring co-operative relationships between the
NEDs and executive directors.
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In 2003, a report on non-executive directors was published in the UK. This was
called the Higgs Report (after its author) and some of the recommendations in the
report were reproduced in the Higgs Suggestions for Good Practice which was
issued as a supplement to the Combined Code.
The Higgs Suggestions include a slightly more detailed list of the functions of the
board chairman. The role of the chairman, according to Higgs, should be to:
Run the board and set its agenda. The agenda should be mainly forward-
looking, and should concentrate on strategic matters (not details of
management).
Ensure that all members of the board receive accurate, timely and clear
information ‘to help them reach well-informed and well-considered decisions’.
Ensure effective communication with the shareholders. The chairman should
make sure that the other directors are aware of the views of the major
shareholders.
Manage the board, and make sure that enough time is allowed for the full
discussion of complex or controversial issues.
With the assistance of the company secretary, arrange for the induction of new
directors after their appointment, and the continuing training and development
of all the board directors.
Organise the performance evaluation of the board, its main committees and its
individual directors.
Encourage the active participation in the board’s affairs by all the directors.
The chairman is responsible for the efficient functioning of the board, and its
effectiveness. He (or she) calls board meetings, sets the agenda and leads the board
meetings. He decides how much time should be given to each item on the agenda.
He should make sure that the board spends its time dealing with strategic matters,
and not matters that should be delegated to the executive management.
The chairman also represents the company in its dealings with shareholders and
(usually) the media. He is the ‘public face’ of the company.
Comparison of the roles of CEO and chairman
The roles of CEO and chairman can be summarised as follows.
CEO Chairman
Executive director. Full-time employee.
Part-time. Usually independent.
Reporting lines Reporting lines
All executive managers report, directly or
indirectly, to the CEO.
No executive responsibilities. Only the company
secretary and the CEO report to the chairman
directly, on matters relating to the board.
The CEO reports to the chairman (as leader of
the board) and to the board generally.
The chairman reports to the company’s
shareholders, as leader of the board.
Main responsibilities Main responsibilities
Head of the executive management team.
Leader of the board, with responsibility for its
effectiveness.
To draft proposed plans, budgets and strategies
for board approval.
To make sure that the board fulfils its role
successfully.
To implement decisions of the board.
To ensure that all directors contribute to the
work of the board.
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3.4 The role of non-executive directors
One of the reasons for having independent non-executive directors on a board is to
give the board a better balance, and to reduce the possibility that the board may be
dominated by one individual or a small group of individuals.
The Singapore Code of Corporate Governance identifies two main roles for NEDs:
To challenge ‘constructively’ and to help to develop proposals on strategy.
To review the performance of management in meeting their targets.
The Higgs Suggestions for Good Practice states that NEDs contribute to the board
in four ways. Two of these are similar to the roles identified in the Singapore Code
of Corporate Governance. The other two point even more strongly to the complex
role of NEDs, in having responsibility for matters that should be kept away from the
executive directors, due to the risk of a conflict of interests. The four roles identified
in the Higgs Guidance are as follows:
Strategy. NEDs should challenge constructively and help to develop proposals
on strategy.
Performance. NEDs should monitor the performance of executive management
in meeting their agreed targets and goals.
Risk. NEDs should satisfy themselves about the integrity of the financial
information produced by the company, and should also satisfy themselves that
the company’s systems of risk management and internal control are robust.
People. NEDs should be responsible for deciding the remuneration of executive
directors and other senior managers, and should have a major role in the
appointment of new directors and in the ‘succession planning’ for the next
chairman and CEO of the company.
These roles suggest that NEDs on a unitary board have the complex task of acting
partly as a colleague of the executive directors, and partly as a ‘policeman’. They act
as a colleague in discussing strategy and helping to develop strategy. However, they
act as a ‘policeman’ in monitoring the performance of executive management,
checking the integrity of financial reporting, evaluating the effectiveness of the risk
management system and internal control system, and deciding the remuneration of
their executive colleagues.
It can be argued that a function of independent NEDs is to reduce the agency costs
arising from the conflict of interests between the shareholders and management, by
acting as independent monitors of the company’s management and also by
negotiating remuneration.
Senior independent director
The UK Combined Code suggests that one of the independent NEDs should be
appointed as senior independent director (SID).
One of the roles of the SID is to act as a leader for the other independent NEDs, for
example by calling meetings of the NEDs to discuss matters away from the
executive directors.
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The SID would also be expected to act in unusual circumstances, when the
corporate governance of the board is not functioning properly. For example:
A disagreement might occur between the major shareholders of the company
and the chairman which cannot be resolved. The shareholders might be asked to
intervene, for example by making sure that the views of the shareholders are
conveyed to the rest of the board of directors. The UK Combined Code states
that the SID ‘should be available to shareholders if they have concerns which
contact through the normal channels of chairman, chief executive or finance
director has failed to resolve, or for which such contact is inappropriate.’
The SID might be required to argue with the chairman or chief executive in a
situation where the company is failing to apply proper standards of corporate
governance. For example, a disagreement between the company chairman and
SID was reported in the UK when the supermarket group Morrison’s became a
listed company. The chairman was apparently reluctant to appoint a sufficient
number of independent NEDs to the board, and the SID argued strongly (and
eventually successfully) that the company should comply with the provisions of
Combined Code.
3.5 The appointment of non-executive directors
It is generally accepted that the board of directors should collectively possess a
suitable combination of experience and skills.
However, in the UK it has been common practice to recruit NEDs to listed
companies from a very small circle of possible candidates. The Higgs Report on
non-executive directors (2003) found that in UK public companies, only 7% of NEDs
were non-British nationals, 6% were women and 1% were from ethnic minority
groups. In many cases, individuals appointed as NED of a listed company were
already an executive director of another listed company.
Following the Higgs Report, the government (Department of Trade and Industry)
set up a committee under the chairmanship of Laura Tyson, Dean of the London
Business School, to carry out an investigation into the recruitment and development
of NEDs. The Tyson Report (2003) reached several conclusions.
The effectiveness of a board of directors would be improved by having a board
consisting of directors with a range of experiences and backgrounds, rather than
a board whose NEDs all come from the same type of background.
Companies should have a formal system of appointing new NEDs to the board.
As part of this formal system, the company should begin by identifying which
particular skills were missing from the board, that the board would benefit from
having. The company should then seek an individual who has the missing skills
or experience that has been identified.
NEDs should be recruited from a wider range of different backgrounds.
Individuals who might make excellent NEDs include senior managers in the
‘marzipan layer’ of corporate management, just below board level but without
yet having any board experience. Other sources of NEDs should be individuals
in private sector companies, ‘professionals’ (accountants, solicitors) and business
consultants, and individuals working on the public sector or the non-commercial
private sector.
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The Tyson Report attracted a large amount of publicity when it was published, but
it is not yet clear that it has had much effect yet on the practice of appointing new
NEDs in the UK.
Keeping the board refreshed
There is a need to keep a board ‘refreshed’ by appointing new directors regularly, to
bring fresh experience and skills to the board.
As a company grows or changes, the skills and experience required from its
directors might change. This means that some of the directors should probably
be changed.
Over time, the independence of a non-executive director is likely to diminish. It
is therefore appropriate to replace NEDs after a number of years.
A new NED might be appointed for a three-year term, and re-appointed for a
further three years if the NED has contributed well to the work of the board in the
first three years. After six years, a company should possibly consider whether a
NED should be replaced.
Changes to the board, to keep it refreshed, affect NEDs rather than executive
directors. This is because executive directors hold senior positions in the
management structure of the company. Once appointed to the board, they are likely
to retain their position as director as long as they retain their job.
3.6 Criticisms of NEDs
NEDs are often criticised for failing to perform effectively in their role. There are
three main criticisms.
Lack of knowledge about the company and the industry or markets it operates
in. NEDs often lack the information about the company that they need to make
well-informed decisions. The chairman is responsible for ensuring that all
directors are properly informed, but this is an ‘ideal situation’ that does not
always exist in practice.
Insufficient time with the company. NEDs might not spend as much time with
the company as they need to, in order to perform their role effectively. When a
NED is appointed, there should be an understanding about how much time the
NED will be expected to spend with the company. Even so, the agreed amount
of time might not be sufficient.
Accepting the views of executive directors. The NEDs might be too willing at
times to accept the views and opinions of executive directors, because the
executives know more about the company’s operations. When the NEDs are too
willing to agree with the executive directors, they do not contribute as much as
they should to discussions on strategy.
In spite of these criticisms of non-executive directors, it is now widely accepted in
many countries that major companies should have a strong presence of independent
NEDs on the board. When NEDs do not appear to be effective in their role,
institutional shareholders might well take action.
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Example
PIRC (Pensions Investment Research Consultants Ltd), a company providing
corporate governance advice to institutional clients, occasionally advises its clients to
use their votes as shareholders against a company’s board. For example in June 2002,
PIRC described Telewest, a cable television company, as a ‘corporate basket case’. It
recommended to its clients that they should vote against the re-election of four non-
executive directors because they were not independent and because the corporate
governance of the company was poor. PIRC argued that the four directors were not
independent because one held share options in the company, two represented the
interests of a major shareholder and the fourth had been a NED with the company
for over nine years. PIRC also commented that the board, including these NEDs, had
allowed large bonus payments to be made to executive directors that were not
justified in view of the company’s performance. (Telewest was subsequently taken
over.)