In the announcement of the review of non-executive directors last month, Derek Higgs commented:
"…it is clearly essential that the right people play the right roles as effectively as possible".
Non-executives have been very much in the headlines recently. Not only was the Higgs review of Non-Executive Directors (NEDs) announced by the DTI but also, earlier this month the National Association of Pension Funds stated that a non-executive director should limit the number of positions he/she holds to five. If the NAPF proposal is implemented, there may be several "situations vacant" in the boardroom. While there may be more vacancies, potential candidates may be wondering if the position is worth it. Recent events have shown, somewhat starkly, that when things go wrong it's no use pretending to be "an elderly widow with failing eyesight and no business experience".*
There's also the threat of legal action from shareholders of companies now suffering severe indigestion from gorging on acquisitions at the height of the "TMT boom". As a result existing (or recently retired) non-executives may now wish that they'd interrogated the executive directors more thoroughly before announcing the deal. Shareholders, of course, are allowed the luxury of hindsight. Regrettably, for directors, it appears that they may not be.
Recently, the outgoing President of the Institute of Directors, Lord Young of Graffham, stated that the role of non-executive directors should be abolished. His reasoning was that it is impossible for them to supervise executive directors in any meaningful way because they do not know enough about their company's business, and could not do so even if they spent up to one day a week at the company (the level of commitment recommended by some institutional investors). He argued instead that all directors should become full-time executive members of the board, and outside scrutiny should be left to shareholders. It is unlikely, however, that his views will find favour with many institutional shareholders or with the Government and regulators. These seem keen to maintain the essence of the established corporate governance regime.
If you are contemplating becoming a non-executive director, an outline of the legal position for non-executives and a checklist of issues to consider when reviewing an appointment letter are set out below. The key messages are:
- do your homework; and
- discuss with your prospective non-executive colleagues your collective role.
In a further note, we shall look at some of the steps that a non-executive director should take if a problem crops up.
Legal position of non-executive directors
English law does not differentiate between executive and non-executive directors. Many think it should. A non-executive director legally bears the same responsibilities as the executive director, but his role is to influence decisions rather than control day to day operations. Nevertheless, both have duties and responsibilities to the company: these include:
- a duty of care owed by the director to the company, having regard to his own level of skill and experience
- and fiduciary duties which include an obligation to act in the best interests of the company and of the shareholders as a whole
- and a duty to act only within the powers of the company as laid down by its constitution.
That said, recent cases have clarified that non-executive directors:
- have a duty to acquire a proper understanding of the business of which they are a director and should attend all board meetings, unless there is a valid reason for absence;
- cannot evade responsibility by leaving decisions to other directors;
- need not show a greater skill than may be expected from a person of their knowledge and experience;
- are justified in trusting company officials to perform duties honestly, but are expected to recognise situations in which it would be wrong to give authority to unqualified people; and
- must not obtain benefit for themselves or others without full prior disclosures, nor make improper use of information for their or someone else's advantage.
Before accepting an appointment
Since all directors share responsibility, a non-executive should do his research on the company and his or her prospective colleagues. With quoted companies, there is normally a substantial body of published information available, such as the annual report and accounts, analysts' reports, circulars to shareholders and press comment. For example:
- Will it be possible to establish a good working relationship with the chairman and the other members of the board?
- How do the other non-executives see their role – for example, supervision or setting strategy?
- How does the board operate?
- Have I been invited to join the board for the right reasons – i.e. am I sought for my general contribution and not just, say, for my special expertise on the cheap?
- Is there a tradition of openness and debate at the board which will allow me to participate properly?
- Does the board have a coherent strategy?
- Are the other directors' standards and ethical values the same as mine?
- Do I have the appropriate qualifications and/or knowledge of this type of business to make a meaningful contribution?
- Will I have any conflict of interest – i.e. will I be able at all times to act independently of any ties to other directors and to place the best interests of the company first?
- If I do have a difference of opinion with the executive directors, am I likely to receive support from the other non-executives or might I be a lone voice?
- Am I likely to be placed in a position where my other interests could conflict with those of the company? Will I be able to manage any such conflict to the satisfaction of the company and its investors?
What's more, it's worth checking whether you're expected to take up one of those "hot seats" at the AGM – namely, membership of the audit or, for that matter, the remuneration committee.
In addition, it would be advisable to enquire as to whether or not the company has taken out Directors' and Officers' Liability insurance and, if so, what the terms of the insurance are and what is covered.
Terms of appointment
It is always advisable to take specific legal advice in relation to terms of appointment as a non-executive director. For example:
- Term of appointment: normally the appointment will be for an initial period of between one and three years, but subject to the provisions in the company's articles of association relating to the retirement and appointment of directors. Ordinarily, these will require a director who is elected to the board during the year to retire from office and offer himself for re-election at the next AGM of the company.
- The Combined Code (see below) recommends that notice periods for directors should not exceed 12 months. The Code also requires that all directors should be subject to election by shareholders at the first opportunity after their appointment, and to re-election thereafter at intervals of no more than three years. Institutional shareholders such as Hermes Investment Management have indicated that they expect non-executive directors to "step down" after a 10 year stint on the board.
- Responsibilities: on a general level, non-executive directors are expected to bring an objectivity and independence of view to the discussions of the board and to assist the board in providing effective leadership and high standards of financial probity and corporate governance. They can also be expected to contribute to discussions relating to group strategy, performance, availability and use of resources and the appointment of key employees and officers.
As indicated above, non-executives will often be asked to sit on one or more of the Audit, Remuneration and Nomination Committees of the board. The Combined Code requires that the Audit Committee comprises at least three non-executive directors, and that a Remuneration Committee should consist exclusively of non-executive directors who are independent of management and any conflict of interest.
In practice, if the results of the company are below expectations, the members must be ready to take some "stick" at the AGM, however unjustified.
- Commitment: the terms of appointment should specify the number of days per year which the non-executive is expected to commit to the company's business. What does the letter say about extra work which might be necessitated by, for example, a takeover or a disposal which requires the greater involvement of non-executives?
- Independent legal advice: the non-executive should be entitled to seek separate independent legal advice about his responsibilities as a director of the company, and be reimbursed by the company for the costs of taking such advice. The Combined Code states in article A.1.3: "There should be a procedure agreed by the board for directors, in the furtherance of their duties, to take independent professional advice if necessary, at the company's expense". For this purpose, the ICSA has produced a "Model Board Resolution on Independent Professional Advice".
- Share qualification: some companies require that directors hold a minimum number of shares in the company whilst they remain in office - clarify any such requirement early on.
- Rewards in shares and share options: The ABI's guidelines on share incentive schemes require that companies should not grant share options to non-executive directors. However, some institutional investors have indicated that they would like to see non-executive directors rewarded by the issue of actual shares in the appointing company. It is worth thinking through the tax issues before agreement is reached.
Areas of particular concern
The Combined Code requires that a board "should maintain a sound system of internal control to safeguard shareholders' investment and the company's assets". The Turnbull Report was produced in order to give guidance to listed companies on the implementation of effective internal controls. The report focused on the need for directors to ensure that a thorough and regular evaluation of the nature and extent of the risks to which the company is exposed is carried out, and that the level of risk is acceptable to the Board. This will depend, among other things, on the maintenance of proper records and processes to generate a flow of timely, relevant and reliable information from within and outside the group, and the effective monitoring of internal controls on a continuous basis. The Report also recommended that companies consider the need to introduce a formal internal audit function in relation to financial controls and, if necessary, other specialist areas such as health and safety, regulatory and legal compliance and environmental issues.
In relation to internal financial controls, the Institute of Chartered Accountants in England and Wales (ICAEW) highlights the following areas as being of particular importance:
- good accounting records;
- regular reconciliations;
- clearance of suspense accounts and review of unusual items;
- "true and fair" year end reporting and reliable interim reporting;
- combating the risk of fraud;
- safeguarding assets from inappropriate use or loss;
- avoidance of losses from derivatives and financial instruments;
- reliable management information from within and outside the company; and
- identification and management of liabilities.
The ICAEW also recommends that directors consider the following:
- agreeing with the external auditors that they will do particular work on higher risk areas;
- inviting individuals in charge of key departments or operating units to attend part of board meetings on a regular basis to account for, and answer questions on, the running of their part of the business and the managing of its risks;
- ensuring that the regular agenda of the board focuses on risk and control on an ongoing basis;
- using confirmations from key employees of compliance with the company's policies and codes of conduct.
The Turnbull Report also identifies the following areas of importance for internal controls:
- Does the company have clear objectives? Are risks identified and assessed on an ongoing basis? E.g. risks related to market, credit, liquidity, technology, health and safety, and reputation.
- Does the board have clear strategies for dealing with the significant risks to the business?
- Are the decisions and actions of different parts of the group appropriately co-ordinated?
- Are there established channels of communication for individuals to report suspected breaches of laws or regulations or other improprieties?
Flow of information
Prospective non-executives should ascertain upfront what information they will get on a regular basis. In law, all directors are entitled to the information they require to carry out their function of monitoring the company’s performance. The quality and relevance of the information is more important than quantity. As a minimum non-executive directors should expect to see the following:
- Monthly consolidated profit and loss accounts, balance sheets and cashflow reported against budget.
- Breakdown of results by strategic business unit.
- Quarterly update of forecast results for the trading year.
- Specific papers on new investment projects above an agreed size.
- Updates on major expenditure such as an acquisition or large building projects; and
- Six-monthly review for the board of progress on the implementation of any strategic plan.
*In the case of Ginora Investments –v- James Capel & Co (1995). The judge said that all directors of a listed public company (both executive and non-executive) would be assumed to have the knowledge, wherewithal and business acumen to run a company of that nature; the directors were not "elderly widows with failing eyesight and no business experience".
For further information, please contact:
Andrew Crawford
Corporate Partner
Phone: +44 (0)20 7367 2867
Email: andrew.crawford@cms-cmck.com
or
Peter Bateman
Phone: +44 (0)20 7367 3145
Email: peter.bateman@cms-cmck.com
