INTRODUCTION

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
1.THE BOARD
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.
5. REMUNERATION
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".
7. CHAIRMAN
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.
CONCLUSION
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.
GovernanceFinance and Banking
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