Corporate Governance –A Brief review on the effectiveness of Non Executives Directors
By Vincent Tung ST, Accountancy Dept, FAM, UTAR
Introduction
Non executive directors (NEDS) are directors that appointed to sit in the main board and board sub committee such as audit committee, risk management committee, remuneration committee and nomination committee. NEDs do not have any executive or management responsibilities as such they are not involved in any day to day operations of a company.
NEDs should provide a balancing influence and minimize conflicts of interest between the executive directors, shareholders and other stakeholders
A survey by Mori in 2003, 62% of NEDS had never received any formal training. The small poll as revealed that nearly half of the NEDs on boards of UK listed firms had been appointed as a result of their personal contacts with other members, while only 4% had gone through a formal interview.1% had applied after seeing recruitment advert.
Higgs Report
The UK higgs report has identified for main responsibilities of NEDs in the following areas:
Strategy- Challenge and assists in developing long term corporate strategy of a company
Scrutiny-Scrutinize the performance management and executives director in achieving the goals and objectives
Risk- Involve in risk management to ensure that company has an effective and robust risk management process
People-overseeing the executive management in the area of remunerations of executive directors and exercising independent judgment to ensure that the conflict of interest within the main and board committees are minimized or resolved
Higgs report also highlighted -“ relevant, significant and clear” information must be provided sufficiently in advance of meetings to enable NEDs to give issues thorough consideration ”.Despite all the guidance even the experienced NEDs have admitted to not knowing what is expected of them.
Tyson Report
The Tyson report on “the Recruitment and Development of NEDS” has identified the following four attributes required by NEDs in order for them to discharge their responsibilities effectively and diligently.
· Integrity and high ethical standard
· Sound judgment
· Ability and willingness to challenge and probe
· Strong interpersonal skills
Issues surrounding NEDs
It has been noted that the major obstacle of improving the effectiveness of NEDs was lack of time or commitment to the company. If an organization has a pool of mediocre or poor performing and timid non-executives on the main board, the executives are unlikely to pay them a lot of attention or allow them much time to challenge their decision.
It was also argued that if NEDs are unable to use their influence effectively in the first few years of their appointment, then the rest of their term on the board, the NEDs could be too comfortable with the board and compromise their professional skepticism. At the end of the day, they might their might lose independence and merely rubber stamp whatever decision made by the board.
The NEDs has great responsibilities, whether it is statutory and in common law but rewards for taking on those responsibilities are tiny. Under the UK unitary board structure, NEDs have the same legal duties and potential liabilities as their executive counter part. This could be the main reason as to why good potential candidates are not keen as there is no legal distinction between executive and non executive directors. Most NEDs are part-timers as they have full time commitment elsewhere, so it might not be fair for them to face the same personal liabilities as those who manage the company on daily basis.
There is also a major concern that firms may not be giving their NEDs the kind of full and reliable information they ought to be providing because they do not want them to challenge the decision proposed by the executive members of the board.
Non Independent NEDs
A NED is not independent if:
· The NED is representing the interest of specific shareholders. If the NED is on the board to represent the interest of a major shareholder, then he will not be regarded as independent because the views given by the director will be seen as influenced by the best interest of that shareholders
· The NED is representing other stakeholders , for example if the company appointed as a NED a director of one its banker then that NED would be seen as representing a particular interest of that specific stakeholder.
· The NED has close ties with the executive directors. This would mean for example that a former chief executive of the company who was given a non-executive would not be independent. In the situation where the NED has a family connection with of the executive director, independence of the NED is also doubted
· Cross directorship arrangement. For example executive director in company X is a NED of company Y and on the other hand the executive director of company Y is a NED in company X
· The NED has financial or monetary interest in the company. For instance holding shares in the company or other form of financial interest
· The term of appointment is too lengthy. It is recommended that, the term of appointment of any NED should not exceed 3 years for each appointment unless under special circumstances (it should not exceed 9 years)
There are three common questions raised in rewarding the NEDS
Question 1: Should NEDs participate in the Bonus scheme?
Implementing a Bonus scheme for NEDs is problematic. If the amount of bonus is too small, NEDs are not motivated. On the other hand ,if the amount of the bonus is significant, they might have the tendency of not acting in the best interests of shareholders for fear of being reprimanded by the executive directors and thereby jeopardizing bonus
Following features of bonus scheme:
· It should be easily understood and able to recruit the cream of NEDs in the relevant industry
· It should be paid in cash or shares ( shall not grant share option)
· Linked to the long-term performance of the company in order to encourage NEDs to take a broader view of corporate governance.
· Prior approval from shareholders should be obtained
· It should include risk management factor in evaluating the performance of NEDs
Question 2: Should NEDs be rewarded in the form of shares?
Some companies reward their NEDs in the form of shares.It was argued that the more equity the NEDs hold, the more likely their interest will be aligned with the shareholders. Thus NEDS will look issues from the perspective of the shareholders
Despite this argument, some people are of the opinion that a NED holding shares could however be more concerned with the short term movements in the shares price and the opportunity of making a short term profit from selling their shares than the long term interest of the company and its other shareholders.
This problem can be overcome by obtaining an agreement with the NED not to sell the shares until after leaving the board.
Issue 3: Should NEDs be granted share options?
The argument against granting NEDs with share options is it could align the interests of the NEDs more closely with the executive directors who also hold share options .NEDs should give independent advice and it can be argued that it is not appropriate to give them incentive in par with the executives.
UK codes of corporate governance states that holding share option could affect the NEDs’ independence. Therefore remuneration for NEDs should not include share options. If options are granted, shareholder approval should be sought in advance
If the NEDs are not properly are effectively rewarded, their contribution in meeting the objectives of their appointments might be not be met.
Conclusion:
The appointment of effective NEDs sitting in the main board and various board sub committees is of the main concern aspect of corporate governance. Most Corporate governance reports acknowledge the importance of having a significant presence of NEDs on the board and various sub board committee. In the Cadbury Report, it is stated that “ The board should include non –executive directors of sufficient character and number for their views to carry significant weight”.
In view of this, company should not simply appoint NEDs for the sake of fulfilling the requirement for the Code of Corporate governance. It should not be concerned only on the ‘form’ of compliance, as the ‘substance’ of compliance should also be equally emphasized. It cannot be conjured out of thin air to the appointment of NED by merely ticking the box but rather the effectiveness of NED to represent the interest of both shareholders and stakeholders should be considered
“Effectiveness requires high level of engagement…It is not sufficient just to turn up at board meetings. Instead individuals need to build their knowledge of the business through all sorts of informal contact with executives, as well as their work on board sub committees. Only with this sort of engagement and understanding of a company can individuals make a credible contribution to board discussions”
-McNulty,Roberts, Stiles,2003
References:
· Neil Hodge reports in June 2006 Financial Management Journal circulated by CIMA
· BPP –P1 ACCA, Study text-Governance, Risk and Ethics
· Kaplan –P1 ACCA, Study text-Governance , Risk and Ethics
· Becker –P1 ACCA, Study text-Governance, Risk and Ethics
· The Tyson Report on the Recruitment and Development of Non-Executive Directors (June 2003)-London Business School
· The Higgs Report- Review of the role and effectiveness of non-executive directors, January 2003