Higgs Reforms Implication Over Non Executive Directors

The coursework question relates with Higgs reforms and its implication over Non-executive directors. The statement mainly emphasized whether the Higgs reforms supported the concept of Non-Executive director to create dynamic and effective corporate governance. This essay will evaluate the theme chronologically in favour of that statement

There are lots of features in corporate governance. It defined as “the systems by which companies are directed and controlled” [1] .To remove principal-agent problem and to ensure the accountability of certain individuals in an organization or company is the prime concern of corporate governance. Economic efficiency is one of the primary aspects of corporate governance. Corporate governance also emphasised on shareholders welfare. The notion of corporate management is quite relates with concept of corporate governance. “Corporate governance …involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaching those objectives and monitoring performance are determined.” [2] It can be said that corporate governance is the set of policies, laws, rules, regulations, customs and processed to control or administered the company. So good corporate governance is like a equipment for socio-economic development.

In the definition of corporate governance there are laid down two prime factors such as;

Organization or Company

Management or Administration

Companies are artificial legal entities so they must work through their human organs [3] . There is a common purpose to establish a company, which is economic purpose. A company have some rights similar to a natural person. The landmark case about company’s legal entity is Salomon v Salomon [4] where stated that the company has its own entity which separate from its members or shareholders. In Macaura v Northern Assurance Co. Ltd [5] , it was held that company can hold its own property. In Re Noel Tedman Holdings Ltd [6] , court said that a company can exist or survives even after death of its members. Company act 2006 provides some specific regulations regarding companies characteristic. Section 16(3) of company Act provides that the company has a legal standing on its own separate from the people who own it and from the people who manage it. [7] This issue of separate entity further discussed in the case of Gramaphone and Typewriter v Stanley [8] , the issue relates with parent and subsidiary company where court held that both company have separate legal entity. There are two types of company in UK such as; public limited company and private limited company.

Management of the company is another aspect of corporate governance. Directors are the main principal organ of the company. Company is an artificial legal entity. It needs real people to represent it and on its behalf. Directors have such powers as are conferred on them by the memorandum and articles of the company. Most modern companies have the following provisions of Table A article 70. In Ferguson v Wilson [9] , Cairns LJ said that “the company itself cannot act in its own person; it can only act through directors.”

According to recent corporate governance there are two types of directors such as; Executive directors and Non-executive directors. Company act did not provide any specific definition of directors. But Company Act 2006 provides some specific duties for the directors.

The coursework question concerns with the issue of non-executive directors and its implication over corporate world to achieve good corporate governance. Higgs reform creates a significant impact regarding this matter. The impact of Higgs reform to achieve a independent non-executive directors would be evaluate chronologically.

Executive director is usually a full time employee and also involves in the day to day operation. A non-executive director is one who is from outside the company. An independent directors who have not been involved previously with the company as a substantial shareholders, consultant, supplier or other relationship which are in conflict with the ability to act in the best interests of the company.

“Although nonexecutive directors tend to be considered ‘independent’ the definition of ‘independent’ may be taken further. For example: non-executive directors are dependent on the executive team for information and knowledge about the company.” [10] Non-executive directors have a managerial and monitoring role and thus have an important role in questioning decisions. [11]

In the 1980 and early 1990s an increase takeovers occurred in the corporate world. The main reason behind that failure was the insufficient and inadequate non-executive directors. This led to growing popularity of the notion of non –executive directors in corporate world. [12] “Corporate governance has been receiving a lot of attention in recent times. High profile corporate collapses in Enron, WorldCom and Parmalat and overseas for example; Ansett, Harris Scarfe, OneTel, and HIH have resulted in increasing attention being paid to issues such as the effectiveness of reporting disclosures, roles of the board, internal controls, audit committees and independence of directors and auditors. Corporate governance is not a new issue; it has evolved with the growth of the capitalist system and the development of world economies.” [13] So it can be said that the concept of non executive director because of management failure which is linked with the term executive directors rather than directors.

There is no precise regulation of the role of non-executive directors. The role of non-executive directors varies from one company to another and continues to develop overtime changing with the changing business atmosphere. A non-executive director can bring a wider, fresh and objective perspective in to the boardroom. Being outsiders their point of views are supposed to be different which can provide updated and informal suggestions. They can enable the board to raise the boardroom policies by internal disputes. Non-executive can attract the investors, thus keeping share prices high. Prominent non-executive directors may also ad credibility and prestige to a company.

UK statutory law does not provide the composition and role of the directors. Under the existing unitary board, the duties of the executive and non-executive directors are quite similar because both sit in the same board and are collectively responsible for the management of the company. [14] So guidelines for composition of non-executive directors in boardroom and roles of the non-executive directors were required. In UK the prominence of non-executive directors developed from the initial reports such as; Cadbury reports (1992), Greenbury reports (1995), Hampel report (1998) and most important Higgs report (2003).

The Cadbury report recommended that, salaries and remuneration of executive directors should be subject to recommendation committee made up wholly or mainly of non-executive directors. The terms of reference were to consider a number of issues in relation to financial reporting and accountability. These included: the responsibilities of executive and non-executive directors, audit committees; responsibilities of auditors and the links between shareholders, boards and auditors. Cadbury recommended that listed companies should comply with the Code of Best Practice. “independent of management and free from any business or other relationships that could materially interfere with the exercise of their independent judgment.” [15]

Greenbury report recommended to disclose directors pay and remuneration of non-executive directors but failed to provide an effective check on directors pay. The Greenbury Report’s review included the recommendation of remuneration committees (to consist of non-executive directors to avoid potential conflicts of interest). This included preparing annual reports to shareholders with full disclosure of remuneration policies for executive directors and other senior executives; and the length of service contracts and compensation when these were terminated.

The Hampell report aims to combine the Cadbury and Greenbury recommendation in a combined code. The Committee prepared a list of approximately twenty ‘Principles of Corporate Governance’ which it believes can contribute to good corporate governance. These principles related to the issues of the role of directors; directors’ remuneration; the role of shareholders; and accountability and audit. Included in the recommendations were further developing the roles and responsibilities of non-executive directors, separating the roles of chief executive officer and chairman; and ensuring that nomination, remuneration and audit committees were composed largely of independent non-executive directors. The combined code does not have the force of law but it is a code of practice.

However the government announced a review of the role of non-executive directors in UK companies. The review was finally carried out by Derek Higgs. In 2002 the UK Government appointed Derek Higgs to review the role of non executive directors. The final report ‘Review of the role and effectiveness of non executive directors’ was published in 2003.

The main significant aspect of the Higgs report is to ensure that the directors are unimpeachable and to the highest quality to get the best possible non-executive talent into the boardroom. 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.

According to Higgs report, non-executive directors have some responsibilities regarding following areas;

“Strategy: To the development of strategy, non-executive directors should contribute.

Performance: The performance of management in meeting the agreed objectives and other monitoring standard should scrutinise by the non executive directors.

Risk: Non-executive directors should satisfy themselves that financial information is accurate and that financial controls and systems of risk management are robust and defensible.

People: Non-executive directors should determine the appropriate level of executive remuneration; play a major role in appointing and removing executive directors and succession planning.” [16]

In order to carry out their duties appropriately, Higgs view is that Non-executive director should understand the company and the sector in which it operates they must exercise proper judgement and high ethical standards. There are some cases where the role and duties of non-executive directors were discussed. In the case of Lexi Holdings v Luqman and others [17] no fundamental distinction is drawn between the duties to supervise management functions delegated to a fellow director. In Re continental assurance co. of London Plc (in liquidation) [18] court held that one of the duties of non executive directors is to monitor the performance of the executive directors. In Re Landhurst Leasing Plc, Secretary of State for Trade and Industry v Ball [19] court said that the question of (excessive) director’s remuneration is quintessentially one which non executive directors might raise.

Higgs recommendation was addressing the critical issue of ‘Independence’. The combined code acknowledges the role and the responsibilities of the non executive director, such as; a balance and independent non executive director [20] and the importance of the non executive directors on the audit, nomination and remuneration committees. “Independence is also essential and is to be a matter of substance rather than form, meaning that any material conflict of interest involving directors will be properly dealt with. All new members of the board and this must therefore include the non executive directors, must have a tailored induction programme covering their responsibilities and the company’s organisation and structure.” [21] The 2003 combined code provides a better solution by including factors relevant to the determination of independence. [22]

Higgs was specifically emphasised to bringing a level independent thinking to the board. According to his view a director needed to be independent of mind and willing and able to challenge, question and speak up. So all director are need to be independent in that sense. He used the terms ‘dispassionate objectivity’ to refer what he means by independence. Higgs suggested that non executive director should be as independent as there is no relation or circumstances which could affect or appear to affect the director’s judgments. Hr provides lots of criteria about the definition of independence. There are some criteria provided by combined code whether a director is independence or not. Such as;

“ has been an employee of the company or group within the last five years;

Has, or has had within the last three years, a material business relationship with the company directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company;

Has received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is a member of the company’s pension scheme;

Has close family ties with any of the company’s advisers, directors or senior employees;

Holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; represents a significant shareholder or has served on the board for more than nine years from the date of their first election.” [23]

The test of independence emanates from the fact, whether such person would be able to exercise; independent business judgment, not subservient to any apparent from of interference. Attribute of an independent non executive director are independent of mind, integrity and ability. The Higgs review also recommends a change to the composition of non executive director in boardrooms, stating that more than half of the board members should be independent. Time will be better saving whether boards grow larger as a consequence.

Probably the most interesting aspect of the Higgs report is that it raises expectation of board performance and place directors talent firmly under the spotlight. Although all companies expect small companies have a nomination committee and their 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. The requirement process for non executive director is not overtaken by the need to build a board that looks good only on paper. Ultimately an effective but slightly non-compliance 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.

There are present some criticisms about non-executive directors. A criticism of non-executive directors is that they are too busy with other commitments and are only involved with the company business on a ‘part-time’ basis. ‘the average director spends only twenty-two days per year on his duties . . . This is barely enough to perform the essential functions. . . , indeed it may be wondered whether the directors who put in less than average effort can be discharging their duties adequately.’ [24] Since the average director ‘spends a little more than two weeks a year’ on the job, it is difficult to ‘develop much more than a rudimentary understanding of their companies’ workings. [25] Non –executive directors do not necessarily have a ‘hand on’ approach and they are not well experienced in the business so that do not make the best decisions. Many commentators like Bhagat and Black [26] in their observations as well as Dulewicz and Herbert [27] recognized that non-executive directors could not provided better results in corporate governance as much they expected.

The effectiveness of non executive directors lies in their ability to secure quality, adequate and timely information. They are however heavily dependent on the executives for information to enable them to make their judgments or challenge management. Another important issue is that as a member of board executive and non-executive directors are both subject to the same legal duties and their liability is same. In Dorchester Finance co Ltd v Stebbing [28] where court held that the liability of executive and non executive directors are same. In the case of Ginora Investments Ltd v James Capel and Co [29] it implies that non executive directors are liable under common law fiduciary duties and the duty of care and skill. In the case Continental assurance Company of London Plc, Re [30] it was held that non executive directors are also liable for disqualification under the company directors Disqualification Act 1986. The introduction of company Act 2006 is codifying the duties of director’s hopes to raise corporate governance standard. But debate still remains unfinished and commentators still disagree regarding the area of role and composition of non executive directors on which no statutory frame work has yet been enforce. This is because since the non executive directors often control the shareholdings of the company, it is unwise to put limitation on their control of the company.

The duties of non executive directors are confusable after the scandals at Equitable Life. This led to calls for a bolder statutory definition of non executive director’s role. [31] Integrity, open-mindedness, trust and independence are all essential qualities around the boardroom table which are impossible to legislate as they are about character. It is evident that without statutory force non executive directors would not be serious about their role and duties. Dual –board system may create some impact on corporate governance regime. EU societas Europaea provides some option regarding the matter of dual-board system which gives EU companies a choice between the two board structure. In this process non executive directors would deal with monitor management and supervisory board. This system will prevent any conflict between management and supervisory functions. Although this two-tier board system failed in Germany because of low remuneration and conflict with executive directors. Unitary board like in UK there are also present some loophole such as; non executive directors could not get proper information in time, non executive directors could not provide sufficient time to the board, management board or major shareholder always create influences regarding the matter of appointment or selection of the supervisory board.

International Company and commercial Law Review 2007 noted that the independence of non executive directors will improve the corporate governance in UK, such as; Firstly, independent non executive directors are likely to introduce a wider, fresh and objective perspective into the boardroom. Secondly, independent non executive directors can help to improve the internal management and general performance of the company.

Thirdly, non executive directors would assure investors to attract investments.Fourthly, independent non executive directors would help to safeguard interests of shareholders and stakeholders. Fifthly, independent non executive directors would assure and check executive director’s function.

The concept of non executive director historically was useless in the area of corporate governance but in current legal structure in corporate arena it’s a burning issue to meet higher standards. In UK listed companies the role of non executive director is that of monitoring management independently. This essay has examined the effectiveness of the non executive directors in corporate world in relation with Higgs recommendation. The maximum role and duties of non executive directors laid down in different reports as well as in Combined Code. But there is still some argument that how can be non executive directors more effective. Two alternatives may introduce to remove all of these problems such as; role and duties of non executive directors may legislate to compel them towards their commitment and adoption of a dual board.

In UK the Higgs Report on corporate governance is one of the latest developments which create a significant impact in corporate world as well as to promote of unitary bodies and the relationship between executive and non executive directors. Higgs recommended for at least one international non executive director with relevant skill and experience regarding all companies operating in international markets. The notion of non executive director is growing popularity all over the world. Although some collapses such as; Enron in USA, Equitable life, Queens moat houses and Maxwell communication etc. occurred for the failure of non executive director. It is submitted that if Higgs recommendation for independent non executive director is implemented properly then it will be a crucial characteristic in corporate governance system.