At the time of writing, the UK’s Combined Code of Corporate Governance was due for revision, following publication of the Higgs and Smith reports in early 2003. In contrast to the legislative approach taken by the US government, the UK recommendations are based on the “comply or explain” principle. Nevertheless, for many UK boards, meeting the demands of the business and satisfying the new governance requirements are going to pose significant challenges in the future.
The primary concern of both the Higgs and Smith reports is to ensure the directors are unimpeachable and of the highest quality – to get the best possible non-executive talent into the boardroom. As the spotlight on the nonexecutive director intensifies, so the burden of accountability and expectation grows. Boards are expected to appoint non-executives who not only satisfy the demands of the code but who also can make a genuine and lasting contribution to the company through their knowledge, wisdom and experience.
For many boards, meeting the demands of the business and satisfying the new governance principles is going to be difficult, even painful. Investor representatives will become more vocal in their demands as their compliance experts scrutinize every aspect of board and committee composition.
The Higgs report makes it very clear that circumstances vary from board to board. Nevertheless, there are those who say that the Higgs report is a “charter for box-tickers.” Sadly, these tend to be the people who have relied on selective press coverage instead of reading the report itself. In fact, Higgs constantly states that he is recommending ideal best practices and acknowledges the need for flexibility.
Indeed, since the publication of his report, Higgs has clarified his intentions in the press as follows: “My message to boards is that if some [proposed rules] don’t fit, and you choose not to follow aspects of the code, explain why in plain language, not in lawyer speak. Stand up and be counted.”
The role of the non-executive director
At the heart of the Higgs report is an examination of the role of the non-executive director. Higgs identifies four key areas of responsibility: strategy, management performance, risk (financial controls) and people (pay, appointments and succession planning). In order to carry out their duties, he says, non-executive directors should understand the company and the sector in which it operates, they must exercise sound judgment and high ethical standards, and they should “question intelligently, debate constructively, challenge rigorously and decide dispassionately.” These are not qualities that can easily be assessed.
Independence
Higgs addresses the critical issue of independence, a word that has caused more problems than any other in the governance lexicon. In his report, Higgs proposes to replace the “multitude of definitions” with new guidelines on independence that incorporate the best thinking on the subject.
He uses the term “dispassionate objectivity” and spells out potential conflicts of interest. But even this requires an element of judgment on the part of each board, which must determine whether its non-executives are “independent in character and judgment” and establish that “there are no relationships and circumstances that could affect, or appear to affect, the directors’ judgment.”
The role of chairman
Some board chairmen have criticized certain Higgs report recommendations, unhappy that they are no longer allowed to chair the nominations committee or hold more than one chairmanship of a FTSE 100 public company. In addition, the suggestion that senior non-executives should be available to shareholders (if existing lines of communication break down) and that they should “chair meetings between non-executive directors where the chairman does not attend” have been given considerable attention in the press. The intention is not to undermine the chairman’s role, but rather to provide additional checks and balances. Finally, the internal route from CEO to chairman is now blocked.
Board composition
The Higgs report also recommends a change to the balance of many boards, stating that more than half of board members should be independent and that there should be more executive representation at the board level. Time will tell whether boards grow larger as a consequence, especially if they wish to keep non-executives who fail the independence test but who nevertheless have invaluable experience and advice to offer.
Indeed, Higgs acknowledges that many of his recommendations may take years to be adopted because of the cycle of board appointments and because of the potential disruption to a business were every issue to be addressed at once.
The extent to which the Higgs report is implemented is a matter for each board to consider, according to circumstances and conscience. Indeed, the code carries no legal weight but is a yardstick against which the investment community can assess the governance of public companies and, if necessary, apply sanctions. Rather than force noncompliant companies through the courts, the code challenges boards to explain themselves and justify their position on governance matters, primarily through their annual reports.
The nomination and appointment process
Probably the most interesting aspect of the Higgs report is that it raises expectations of board performance and places director talent firmly under the spotlight. Although nearly all FTSE 100 companies have a nomination committee, most smaller companies do not, and the committee’s purpose varies enormously from board to board. Higgs emphasizes the importance of a transparent, merit-based appointment process, which should be conducted in a “rigorous, fair and open” manner. In addition, the nomination committee also should oversee the company’s senior-level succession planning.
Furthermore, there is widespread agreement that the pool of non-executive directors needs to expand, and measures have been put in place to uncover candidates from outside the business community. Identifying a diverse set of fresh candidates and persuading them to take on more onerous non-executive roles will be a challenge, which is one of the reasons Higgs invites company chairmen to encourage their executive directors and senior management to take on a non-executive directorship on a non-competing board.
The Smith report
It is a particular challenge to find willing and qualified candidates prepared to sit on audit committees, whose members need to be, in Smith’s words, “tough, knowledgeable and independent.”
The Smith report offers guidance to audit committees:
The work of the committee should “go beyond catching inappropriate reporting or inadequate auditing… [it should] be more pervasive and seek to build a culture of compliance and fair reporting,” resolving matters before they cause real concern. Those joining an audit committee must walk a fine line between challenging auditors and finance executives and getting drawn into the details when concerns are raised. Not every member will be equipped to handle this delicate balance, nor will they have the confidence to remain robust and persistent in the face of suspect accounting practices.
The Smith report illustrates the gulf that exists between the American and British approaches to the governance debate. For example, whereas Sarbanes-Oxley imposes strict rules on US companies by prohibiting an external auditor from providing any other consulting services, Smith states: “We are skeptical of a prescriptive approach, since we believe that there are no clear-cut, universal answers.”
Finding the right people
The UK preference for voluntary codes and self-regulation allows for a more pragmatic approach to governance than would be possible through legislation alone. There is still some latitude for boards to explain if they are not willing or able to comply. This is particularly important when it comes to finding the right people to serve at the board level. Any tendency towards “box-ticking” must be offset by an understanding that each company’s needs are unique and constantly changing. Self-regulation allows for flexibility in board composition, without compromising the qualities that should underpin every non-executive’s role.
It is crucial that the recruitment process for non-executive directors is not overtaken (or undermined) by the need to build a board that looks good on paper (i.e., the annual report) but is less than the sum of its parts. Ultimately, an effective but slightly non-compliant board is of far greater value to a business and its shareholders than a dysfunctional board that satisfies all the criteria for good corporate governance.
Integrity, open-mindedness, trust and independence are all essential qualities around the boardroom table but are impossible to legislate — they are about character. As Higgs puts it: “The key to non-executive effectiveness lies as much in behavior and relationships as in structures and processes.” Clearly, as they seek to strengthen themselves, boards must pay proper attention to evaluating personalities and understanding group dynamics.
The Higgs report also makes a strong case for more diverse representation on boards, although this must be balanced with the need for knowledge and experience. While director
talent may indeed be locked inside the public and nonprofit sectors, pinpointing the transferable skills and managing the transition into a commercial environment will be a significant challenge.
Conclusion
At the time of publication, the debate over how the Higgs report would be incorporated into the UK’s Combined Code of Corporate Governance had lost none of its intensity. There is no doubt that the composition of boards is set to change, along with the role and responsibilities of non-executive directors. Given the increased scrutiny on boards by shareholders, not to mention the media and the public, attracting the right kind of
new talent into the boardroom is going to be a significant challenge in the future.
About the authors
Carolyn Eadie is global leader of Spencer Stuart's Financial Officer practice and a member of the UK Industrial and Board Services practices.
David Kimbell is the European leader of the Board Services Practice.
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