It has largely become a standard article of faith that every public company needs good independent non-executive directors. Paul Myners in his ‘Review of Institutional investment in the United Kingdom’ in March 2001 went so far as to say that “non-executive directors are now placed at the heart of corporate governance”.
The European Commission (EC) has expressed similar sentiments, particularly where potential conflicts of interest arise – for example, the remuneration of directors, or the supervision of the audit of the company’s accounts.
On 5 May 2004, the EC issued a consultation document defining minimum standards applicable to the creation, composition and role of the nomination, remuneration and audit committees. The consultation period has just come to an end.
We look here at the proposals which will form an EU recommendation to member states for adoption in early autumn.
The Commission did not set out to produce an EU-wide code on corporate governance. It recognised that some member states, such as the UK, operate a one-tier board structure with a single ‘administrative board’ having both executive directors engaged in the day-to-day management of the company and non-executive directors who are not.
However, other states have a two-tier board structure, with both a ‘managing board’ composed of directors engaged in the daily management of the company and a ‘supervisory board’ composed of supervisory directors responsible for overseeing the managing board’s activity.
Yet other states permit companies to choose on which basis to operate. The Commission therefore aimed instead to persuade states to introduce for listed companies established in the state concerned as a minimum a set of detailed principles to apply to supervisory directors in a two-tier regime and to non-executives under a one-tier basis.
The recommendation would require member states to introduce a ‘comply and explain’ requirement, under which the companies would either comply with the code, or annually have to explain to shareholders the reason for non-compliance. Although the principles are primarily designed for listed companies, the Commission would encourage their extension to non-listed companies.
The recommendation would see the role of non-executive directors (or supervisory directors in a two-tier regime) as crucial in three fields: the nomination committee, remuneration committee and audit committee. It would therefore anticipate a sufficient number of independent non-executive directors so that they could play an effective role in these areas.
Although the company board ultimately has sole statutory decision-making authority, the recommendation would provide for these three committees to make recommendations aimed at preparing for board decisions and ensuring that these are based on due consideration.
Profile of non-executive directors
If non-executives are to play an effective role, the recommendation would expect them to demonstrate that they have both the required skills and time to fulfil their role. Both before and throughout their appointment, adequate information would need to be provided in this regard.
Although the company itself would determine what this entails, specific competence would be needed for appointment to the audit committee. Thus, the recommendation is likely to include a statement requiring at least one member to have had recent relevant experience resulting in sophistication in finance and accounting and the remaining members on appointment to be able to read and understand financial statements.
New directors would be required to follow a tailored induction programme covering the company’s organisation and activities and the responsibilities that they would have as directors. The company’s annual report would have to include an explanation of why all individual directors were qualified to serve on the board.
The Commission does not propose including in the recommendation any provision imposing a strict limitation on the number of directorships an individual may hold, but will include a general statement that each director should apply the necessary time and attention to his duties and limit the number of directorships held in other companies to the extent necessary to assure proper performance of those duties. When an appointment is proposed (and in each subsequent year), the director’s significant other commitments should be disclosed, together with the time involved in each.
Corporate governance codes generally require a significant proportion of the non-executive or supervisory directors to be independent, ie without close ties to any of the management, controlling shareholders or company. The Commission suggested the inclusion in the recommendation of a general statement on the lines of: “A director is considered to be independent when he is free from any business, family or other relationship - with the company, its controlling shareholder or the management of either - that creates a conflict of interest such as to jeopardise exercise of his free judgement.”
The Commission proposed as minimum criteria that to be independent a director should not:
q be an executive, managing director or company employee (or have been in the preceding five years) of the company or associate company;
q receive additional remuneration from the company or associate company apart from non-executive director’s fees;
q be or represent the controlling shareholder(s);
q have (or have had within the past year) a significant business relationship with the company or associate company;
q have been the partner or employee of the external auditor within the previous three years;
q be an executive or managing director in another company where any of the company’s executive or managing directors is a non-executive director in that other company;
q have served on the board for more than 12 years; or
q be a close family member of an executive or managing director or other persons specified above.
Due to the specific circumstances of the company or individual, the board might still hold someone not to be independent, even if the above criteria are all met. However, a shareholding that does not give control of the company does not in the Commission’s view compromise independence.
The Commission will include in the recommendation a general statement about independent directors’ duties which each would be required to undertake, namely:
q to maintain in all circumstances his independence of analysis, decision and action;
q not to seek or accept any unreasonable advantages that should be considered as compromising his independence; and
q to express clearly his opposition in the event that he finds that a decision of the board may harm the company.
The recommendation would see the roles of the three relevant committees as covering the following areas.
Nomination committee: This would identify and nominate (for board approval) candidates to fill board vacancies, evaluating the balance of skills, knowledge and experience of board members, describing the roles and capabilities required and assessing the time commitment. It would periodically assess the structure, size and composition of the board and recommend changes and assess and report on the skills, knowledge and experience of individual directors and consider issues related to succession planning.
Remuneration committee: As regards executive or managing directors, this committee would make proposals to the board on their remuneration policy, addressing all forms of compensation, including fixed and performance-related pay and pension and termination arrangements, with recommendations on objectives and evaluation criteria and ensuring individual executive remuneration is consistent with the company’s remuneration policy. It would also make proposals on a standard form of contract for executive or managing directors and oversee the process regarding compliance with disclosure requirements.
It would also make recommendations on, and monitor the level and structure of remuneration for, senior management.
It would debate, and make proposals on, the general policy on stock options, review the information provided to shareholders and make proposals about the choice between granting subscription or purchase options and the reasons for, and consequences of, the choice.
Audit Committee: As regards the company’s internal policies and procedures, the audit committee’s role would be to monitor the integrity of the financial information provided by the company, reviewing its accounting methods. It would review the internal control and risk management systems to ensure that the main risks are identified, managed and disclosed and it would ensure the effectiveness of the internal audit function, including selection or removal of the head of internal audit, the department’s budget and management’s responsiveness to its recommendations.
The Committee would make recommendations about the selection, appointment and removal and terms and conditions of engagement of the external auditor, monitor his independence and objectivity and investigate issues leading to his resignation, making consequential recommendations.
It would also review the effectiveness of the external audit process and management’s responsiveness to the external auditor’s recommendations and keep the nature and extent of non-audit services under review.
Unlike an EU regulation or directive, a recommendation is not binding, but it is probable that its proposals will be applied by all member state governments. We wait to see whether the recommendation will be amended significantly following responses to the consultation.
Bill Birmingham is a senior consultant at Lane Clark & Peacock LLP actuarial consultants in the UK.
The views expressed in this article are those of the author and not necessarily those of LCP as a firm