Effectiveness of Non Executive Directors

Discuss the effectiveness of non-executive directors as a good corporate governance mechanism.

Non-executive directors (hereinafter referred to as NEDs) are not established by statute but like other directors of a company, NEDs have to comply with the duties of directors which have been established by common law and case law, such as the duty to exercise care, skill and diligence. [1] Alternatively, their existence is grounded in recommendations and the introduction of a succession of codes of good corporate governance practice. Corporate governance mechanism was as a result of a series of unexpected corporate collapses and concerns about directors, who pursued their own interest such as pay increases and expensive takeovers to the detriment of shareholders. This necessitated the financial authorities and the government to commission these reports: Cadbury Committee, 1992; Greenbury Committee Report, 1995; Hempel, 1998; Turnbull Report, 1999; Smith Report, 2003; Higgs Report, 2003. The latest Code, the Combined Code on Corporate Governance (first published in 2003), [2] which has its main provisions harnessed into the listing rules. [3] This publication was on the importance of a company’s non-executive on the board and its main committees, [4] with emphasis on the independence of NEDs in line with their role as provided for by the code. As of importance the UK has maintained a traditional ‘comply or explain’ approach to company governance since the introduction of role of NEDs in the early 90’s through the Cadbury Report, headed by Sir Adrian Cadbury. Under this viewpoint companies are expected to conform to the provisions of the code in their annual reports by stating how they have complied or otherwise offer an explanation to the shareholders as to why not. This method though no legal consequence involved has re-aligned the management activities of a higher number of companies as they have increasingly come under scrutiny. The Financial Reporting Council has since then received several positive feedbacks on this step.

An assessment of these provisions with due regards to the criticisms of the role of a NED on the board and board committees as an effective corporate governance mechanism is what this paper seeks to do. It will also assess the potential liability of the duty of diligence and skill which comes with this position and areas which could improve their effectiveness.

A NED is a member of the board but without executive responsibilities in the company. While a NED is expected to bring independent judgment and experience to the board, he is not saddled with operational responsibilities of running of the business which executive directors have. His key role is dual in nature i.e. supervisory and managerial. This will be to function actively in the areas of reviewing performance of the board and that of the executive and exhibit independent judgment where conflicts arise between the interest of the company as a whole and that of an executive. A NED does not only exhibits expertise on deliberations of the board in the area of strategy and business development, but also ensures that there is a suitable balance of power on the board where necessary and influences the chairman over board decision making with independent judgment. He should therefore understand the company’s business, attend meetings and function actively in the decisive affairs of the company through compliance with legal and corporate governance policies. It is generally agreed that the experience required of a NED could be obtained from working in similar or other industries, however in reality he could be an executive in another public company, have professional qualification, experience in government or hold a chairmanship or non-executive position in other companies.

Consequently, a company must be run by an effective board of directors who ensure that company goals are met. [5] The UK runs a unitary board system which is rather unambiguous with main responsibilities to implement business strategies on behalf of shareholders and to ensure that business activities are conducted in line with company law and other requirements. [6] Therefore the board should set value and standards;

“Provide entrepreneurial leadership, by ensuring that a proper planning process is in place, ensuring that adequate resources are allocated in line with the plan, reviewing progress against the plan, taking whatever corrective action is necessary with regard to the management of the company". [7] 

The board consists of individuals with personal views and interests; a central issue in corporate governance which is the balance of power and influence among the board members; as some are in reality more powerful than the others especially the chairman and CEO. [8] It is good practice that there should be checks and balances to prevent particular domination of the board or its decisions. [9] In the absence of these, are the possible dangers similar to the infamous corporate collapses in the 90’s like Polly Peck in the UK and Enron in the US; which have similar institutional characteristics. This has brought about a revamp of the boardroom activities in corporate governance. The actual size of a board is not given by the code; [10] but it provides that it should be a balance of executives and NEDs such that no group or individual dominates the board and that smaller companies should have at least two independent NEDs while listed companies; one half the board excluding the chairman should be independent NEDs. [11] 

The significant authorization given to NEDs by the combined code is a departure from the other reports and it remains the major difference. This it did by shifting power from executives whose decisions could easily be influenced by personal interest and placing more emphasis on the independence of NEDs so as to bring unbiased objectivity to the decision making of the company. [12] Where the criterion for performance is whether they can influence outcomes and add value without undermining management activity or decision. By this, NEDs will need to develop a highly objective and professional approach and be capable of expressing independently held views in line with business objectives and legal compliance which is in the overall best interest of the company and its shareholders. [13] While it is good corporate practice that the chairman is separated from the CEO, the code requires that the chairman should ‘be an independent non-executive when first appointed’ [14] after which he is not considered independent for the purposes of the committees. This is due to the consequences of their various roles; while chairman ‘runs the board’ the executives ‘runs the business’. [15] 

Notable amongst the many issues that has arisen since the first review of the presentation of the consultation paper (Higgs 2002), was the expectation of the performance probable of NEDs. Firstly, is the fact that they are mostly drawn from a particular camp which could jeopardize independent judgment. The pool network has a higher likely hood of negativity on the experience and expertise which would have ordinarily been an advantage for their appointment. Majority of individuals appointed to NED positions are often chief officers in other companies and are reluctant to criticize a fellow CEO. Therefore their functionality as a non-executive can become biased over time, due to existing informal liaison with one another and the nagging tendency to help each other out in certain times. For example, NEDs have personal interest in the decision of the value of executive remuneration since such information is recycled amongst them to determine their own pay as executive directors of other companies. This kind of support may cause unquantifiable damages to companies and its shareholders. There is also the issue of connivance in a malicious take over. Secondly, as part-timers on the board, there are concerns as to whether they can realistically give objective opinions due to information asymmetry caused by limited involvement with the operational activities of the company, it is argued that they are excluded from internal decision making which ‘bedrocks’ businesses. In essence they do not necessarily avert disastrous strategic decisions and might just end up just ‘sealing’ management decisions. This issue is further complicated as most NEDs occupy other full time executive positions or non-executive positions in other companies, thereby dedicating insufficient time to any one company. Other important criticisms include the lack of the law to play a more enforcing role in stimulating NEDs to take appropriate action against executives who are insubordinate or negligent in their duties by imposing liability personally where loss can be attributed to an act or inaction by an executive. The new companies act, [16] and case law does not differentiate directors in terms of duties as they are still governed by the common law as regards any breach of fiduciary relationships with the company. Though before the developments establishing NEDs, non-executives were silent and just filled the numbers on the board. Today non-executives have increasingly become liable for their actions or inactions due to the requirement duties to exercise independent judgment, skill, diligence and care as encapsulated in the new act.

In Lexi Holdings Plc v Luqman, [17] the strong approach taken by the Court of Appeal shows that history now accounts for the days when NEDs could be inactive or be willingly or unwillingly ignorant of the affairs of the company. The court took a different view from that of the lower court and found the NEDs to be liable in the amounts claimed by Lexi. The Court of Appeal noted that the NEDs in question both knew of the managing director’s prior convictions and should have known that his behaviour needed close supervision. There was a duty on them as directors to ask probing questions in respect of his relevant business dealings, and to be diligent in considering the explanations provided by the managing director as to these dealings. It was emphasized that a board of directors must not permit one individual to dominate and use them. In other words, it may in itself be a breach of duty for directors to allow themselves to be dominated by another director. This not only justifies the provisions of the code but also the provisions specifying directors’ duties under the new companies act. [18] Nevertheless the courts realize that non-executive directors’ duties are essentially supervisory. They would thus be required under s.174 of the Companies Act 2006 to monitor the financial dealings of a company and not to prevent fraud or have custody of asset.

Similarly, a CEO may be absolved of liability where a company does not meet its targets or goals, instead the directors are liable and this may sometimes be in a personal capacity depending on the extent and nature of the breach. This is another fundamental issue to the extent that qualified and experienced individuals have increasingly began to decline the post of NEDs due to the raised bar in responsibilities and management decisions exposing them to personal liability and a huge compensation in damages. Increasingly, there have been advocacies for individual statement of independent directors to be included in financial reports; this is should be an area of address in the revised combined code. Moreover, the presence of NEDs on the board does not necessarily prevent an all powerful CEO dominating the board or any of the board committee. [19] 

It will be unfair of this assessment not to mention the laudable contributions the combined code recognizes in NEDs to bring to the board of a company. The code provides: ‘…they should satisfy themselves on the integrity of financial information and that financial control and systems of risk management are robust and defensible’. [20] This is authoritatively backed by the provisions of the new company’s act which includes promoting the success of the company, exercising independent judgment and carrying out their required duties with expertise, diligence, care and skill. In terms of legal compliance and corporate governance requirements, NEDs are responsible for financial disclosures in the annual reports which should satisfy all company stakeholders. This they will do by bringing in their wealth of experience and expertise to the board since they must have and or; function in similar roles before their appointment. Incidentally this has been fashioned in such a way that they are independent of the executives and do not contribute to daily operations of the business, instead they channel a wider course of perspective for the overall success of the company. For example Finance experts on the audit committee and on the board may be perceived as promoters of disclosure transparency. The code now prescribes a more rigorous form of assessment, professional development trainings and re-election process. [21] The balance of power between the board and other stakeholders remain one of the most important functions of NEDs in corporate governance. Their presence on the nomination and exclusivity on the remuneration committees strengthen their position for determining appropriate levels of remuneration of executive directors and in appointing and removing executive directors where necessary. In view of the fact that the underlying principle of code states that: “Every company should be headed by an effective board". It is preconditioned that corporate success will be determined by the effectiveness of its board which through its NEDs must have complied with the codes or served to explain why it has decided not to comply.

Like the previous codes before the combined code, the financial reporting council (FRC) undertakes regular reviews of the impact and implementation corporate governance codes to ensure that it continues to work effectively. The combined code also recently experienced a review in line with developmental changes in corporate governance and practice. It is envisaged that the latest review is due to take effect sometime in April or May this year will consider some areas of improvement as a change of name which should

confirm the UK’s recognized corporate governance standard for companies especially to foreign investors and foreign companies listed in the UK. It is intended that it will give more importance to some aspects which undermine effective board functioning. The changes proposed are structural as well as reflect recommendations made by Sir David Walker which does not in any way criticize the underlying principles of the code. These include some changes and additional provisions amongst others:

‘A provision for the chairman to agree to personalize training of each director every three years by an external consultant and this is a new provision; [22] Board should also be made more aware of their responsibilities by putting systems in place that properly identify, evaluate and manage probable risks’. [23] The House of Commons also suggested that the annual report should include an explanation of the company’s business model and overall financial strategy. [24] 

Under the comply or explain principle, the larger companies may be able to justify their reason for non-compliance while the smaller companies will care less about any such compliance due to less involvement with institutional investors who will otherwise sometimes force this out of the boards of the large companies. A more obligatory provision such as a set limit of this requirement is therefore in order and will liminate the double standards which may have indirectly hampered some business expansions.

The gap between a director and chairman’s remuneration is still quite wide as statistics have shown, though there has been an increase to the remuneration accorded to NEDs, [25] justifying the increased responsibilities. The pay should equally be sufficient enough to persuade them to devote the necessary time to a company and possibly forgo other appointment invitations.

Appointment of NEDs for a limited fixed term only, renewals through elections after the first appointments may cause NEDs to loose their independence. For example a NED in his retiring years may not have the same competitive advantage as he did in the earlier part of his career; this may cause him to get comfortable with the appointment, satisfy a cabal of executives and stay on the job for the rest of his life without any real drive for the success of the company.

While the recent codification of directors’ duties does not differentiate the level of skill required of a NED from an executive director, it is a positive step in reinforcing the importance of the position. The code should also include a proviso to reiterate the importance of this position and possibly include a form of sanction for a breach of duty.

This assignment has explained the central importance of the role and effectiveness of NEDs as a corporate governance mechanism. It has also shown the best practice guidance relating to NEDs and the board through the provisions of the combined code which includes upholding the highest standards of integrity and probity; questioning intelligently; challenging thoroughly and deciding independently; supporting the executives in their business function while limiting their empire-building tendencies by similarly monitoring them; gaining trust and respect of board members and promoting success of the company. It also did not over look the potential areas of liability due to existing structures concerning governance of companies especially legislature. The activities of corporate practice in the last decade has shown wide embrace of the role of non-executives as good corporate mechanism. Pricewaterhousecoopers’ reported, [26] that board effectiveness of all industrial and service industry participants who have currently reviewed their board to be 84%, committee and individual directors’ performance of similar figures (83%) reported in financial organizations. Though there is a clear difference between small and large companies, annual performances of review of board committees are 91% and 63% for smaller companies. The constant review through stakeholder consultation also evidences pro-activity and growth in this area. [27] It is hoped that the areas of improvement mentioned by this paper will be encapsulated in the revised code due in this year.