Corporate Clips

CORPORATE GOVERNANCE - THE IMPORTANCE OF THE NON-EXEC

April 2003

In the wake of Wall Street scandals, such as Enron and WorldCom, and disastrous problems at such companies as Marconi and, more recently, Cable & Wireless, corporate governance issues and the role of the non-executive director have come under the spotlight. Prior to this, the role of the non-executive was somewhat unclear and subject to criticism by executive directors. Tiny Rowland (the late CEO of Lonrho) once likened them to "Christmas tree decorations" and, more recently, Camelot Chairman Sir Michael Grade asked what the difference was between a non-executive director and a supermarket trolley, the answer being that a supermarket trolley "has a will of its own".

Many now see the non-executive as a panacea to the recent corporate problems - that, by effective monitoring of board activity, such scandals and problems in both private and public companies can be avoided. However, this one dimensional view of the non-executive's role comes in part from the US experience (where regulators have tended to emphasise the monitoring role of non-executives) and ignores the other roles undertaken by a non-executive in the UK framework of corporate governance. The private equity market, where major shareholders have a more active participation in a company's business, has always been aware of the importance of quality, independent non-executives and the variety of roles they undertake and this is now becoming more generally recognised.

Back in 1998, the UK Hampel Committee[i] recognised that non-executives are appointed to the board for both their contribution to the company's strategy and as a monitoring function. In relation to smaller companies, it noted that non-executives may also contribute valuable expertise, particularly to inexperienced management teams. The comments of the Hampel Committee are supported by Derek Higgs in his DTI sponsored "Review of the Role and Effectiveness of Non-Executive Directors" (published on 20 January 2003)[ii]. Although the Review was prepared with an emphasis on the listed company sector, it has implications for the private equity market.

In the Review, Mr Higgs comments that a non-executive's role is "both to support executives in their leadership of the business and to monitor and supervise their conduct" and, in relation to smaller companies to "provide specific expertise or experience to complement that of the executive team".

Recognition that non-executives perform a variety of roles inevitably raises the question of scope. Derek Higgs, perhaps taking a leaf out of private equity experience (where there has been recognition that the role of the non-executive needs to be clarified) suggests in the Review that a detailed letter of appointment be entered into and the Code on Corporate Governance be amended to describe the role of the non-executive, such role to include:

taking impartial decisions on those matters where executive directors have personal interests (e.g. terms of remuneration and the preparation and audit of the company's annual report);
reviewing the strategy of the company;
scrutinising management performance;
ensuring that adequate information and controls are in place; and
appointing and, where necessary, removing senior management

There are also recommendations as to the steps a non-executive should be taking, including meeting with and gaining an understanding of the views of major investors, ensuring independence (the recommendation being that a non-executive should not, as a rule, be given options in the company), gaining a detailed understanding of the business of the company and the market it operates in and limiting the number of boards sat on.

A key concern for non-executives, particularly given current expectations and following action against non-executives in the Equitable Life case, is that under the English law concept of the unitary board there is no distinction between the duties of executive directors and those of non-executive directors, despite their differing roles and day-to-day knowledge. Directors duties are founded in various statutes (such as the Companies Act, the Insolvency Act and environmental and health and safety legislation) and breach of such duties can have far ranging consequences. By way of example, under the Enterprise Bill[iii], due to become law this year, the Office of Fair Trading will have the power to apply for the disqualification of up to 15 years for directors of companies which breach competition law. In addition to directors' statutory duties are general duties owed by directors to their companies, which set standards of propriety of conduct and skill and care, which have been established over time through case law. These include the classic 'fiduciary' duties:

not to make unauthorized profits;
to avoid conflicting interests and duties; and
to act in good faith in the best interests of the company

Added to the legal risk, of course, is the reputational risk faced by a non-executive in the event that a company gets into difficulties.

In the Review, Mr Higgs rejected the argument that a non-executive's duty be limited by way of proportional or capped liability or a business judgement defence as, amongst other things, this would create the danger that boards will be divided. However, the Review helpfully suggests the actions of a non-executive be judged against the background of the description of the role of the non-executive, to determine what could reasonably be expected of him. The Review also proposes that:

companies should provide appropriate directors' and officers' insurance and supply details of the insurance cover to non-executives before they are appointed (and various City institutions including the City of London Law Society and the British Insurance Brokers' Association have agreed to draw up guidance on obtaining appropriate directors' and officers' insurance);
companies be allowed to indemnify directors in advance against the reasonable;
cost of defending proceedings against the company itself without (as currently required) establishing in advance the prospects of the case; and
the principles set out by the Company Law Review (presented in July 2001) be taken into account when criminal sanctions in relation to directors are being considered by the Government.

Against this backdrop there are lessons to be learnt by both non-executives and the companies appointing them. The non-executive should insist on a letter of appointment specifying his role, ensure that appropriate directors' and officers' insurance is in place, attend all board meetings, ensure that he has the same rights of access to information as executive directors, that he is independent (and perceived to be independent) and that he is fully informed of the company's affairs. A board appointing a non-executive should appreciate the importance of getting the right person for the role (and the importance of adequate remuneration to attract that person) and understand that the role of a non-executive is to work with executive directors in adding value to the company and to act as a custodian of the corporate governance process - in order to perform this role, and in view of the potential liabilities, the non-executive must have the necessary information and assistance.

Lucy Vernall/Charles Claisse

[1] http://www.ecgi.org

[2] A copy of the Higgs Report can be found at http://www.dti.gov.uk/cld/non_exec_review/pdfs/higgsreport.pdf

[3] http://www.parliament.the-stationery-office.co.uk/pa/cm200102/cmbills/115/2002115.htm