Position of a Non Executive Director

In 1962, Lord Boothby expressed in a typically downright and impish style the position of a Non-executive director as follows: [1]

If you have five directorships it is total heaven like having a permanent hot bath- No effort of any kind is called for. You go to a meeting once a month in a car supplied by the company, you look grave and sage, and on two occasions say, ” I agree,” say ” I don’t think so ” once, and if all goes well you get £300 a year.” [2]

Unarguably, in the past it was a cakewalk to become a non-executive or independent director if you were a leading politician, retired officer in the defence forces or bore a title. The work was not onerous. It required showing up once a month, acquiescing to the arguments presented before them, and then relishing a good lunch, all for some 500 guineas a year. [3] However, the role of non-executives has certainly moved on from that preferred by Lord Boothby in the 1960s. [4]

Introduction

Non executive directors (NEDs) have been present on the boards of public companies for many years now. Primarily, they were the people who by their name or status gave credibility to the company from the public’s perspective. [5]

The terms, ‘non-executive director’, ‘outside director’ and ‘independent director’ are more or less interchangeable. [6] The former is widely used but has perhaps a somewhat negative flavour; the second is common in the US; and the latter is becoming more and more popular lately, mainly because the idea of independence is usually underlying in the nature of the role. [7] In fact, the expression “independent director” was included in Corporate Governance dictionary only in the 1970s as the kind of director capable of executing the monitoring role. [8] Until then, the board was divided into “inside” and “outside” directors. [9]

Often technically non executive directors used to be passive, ineffective, and otherwise were found under the management’s influence, as famously described in Myles Mace’s 1971 book. [10] Almost two decades later, Jay W. Lorsch and Elizabeth MacIver argued that the non executive director was still more likely to be a “pawn” than a “potentate.” [11] Often these directors did not feel that they had a duty to see that the company was properly run, and that they should exert influence when it was appropriate. This resulted in the many jokes about “guinea pig” directors [12] . [13]

However, in the last few years new life has been breathed into the role of the non-executive, their image has been constantly improving, their work profile re-defined and their contribution on the Board has risen above having to act only as a reputational intermediary who’d lend or ‘pledge’ its reputational capital to the corporation, thereby enabling the investors or the market to rely on the corporation’s own disclosures or assurances where they otherwise might not. [14] Their position at present is becoming significant for the transparency and accountability of companies, but also their competence and business credibility. [15]

Before discussing how the role of the NED has developed, how they are selected, how is their independence assured, how may their effectiveness be assessed, what other major changes have taken place and what caused these changes, let us first get a grip of how did this concept of having independent directors on a company’s Board emerged and what were the pre-requisites for appointment, specifically in the UK.

In retrospect…

It was never simple to find directors who were willing and essentially able to fulfil their duties on boards. A previous charter issued in the late 16th century by the Bank of England listed the qualities that were required in members suitable for appointment to the court of governors. The Queen of England was looking for appropriate gentlemen with ‘sufficient leisure’ (i.e., time to do the job properly) and ‘opportunity’ in order to ensure they were suitably secluded from the throng of daily matters (in order to work competently in best interests of the Bank of England) and ‘honourable’ (as moral sense and integrity were as significant as business acumen and dedication to the job) [16] . Simply put, it seemed essential to outline the required qualities in a director at this initial stage. [17]

In the 1700s, undoubtedly several suitable gentlemen could be found in London enjoying a relaxed afternoon in the English coffee houses or during the smoking sessions at a pub. [18] Potential candidates would be recognized by their social standing and their connections with influential people. Your social status was your USP. Nevertheless to be considered suitable for an invitation to be a director it was better to ensure that you were a ‘Gentleman’. [19]

Three hundred years later the Bank of England was in the middle of the first initiative in the UK to go beyond personal relations and unofficial references in order to establish a cadre of NEDs. The reason was the secondary banking collapses in the 1970s in which the UK’s Central bank acknowledged that inefficient boards played a critical role in the financial crisis. It was evaluated that the Bank’s own function of administering the financial system was not equal to the task of ensuring stability unless there were capable and goal oriented directors supervising the executive board. Independent and efficient directors were better suited to ensure risks were appropriately handled and thereby contribute not only to the bank’s own protection and success, but the robustness of the whole of the banking system. [20] The Bank of England realized that there was a public interest at risk, as when bank’s crashed the consequences were intense for depositors and could quickly threaten the whole economy. The need was evident but the solution carried some intimidating challenges.

The Bank came together with a number of other organizations like the LSE, the British Bankers Association, and couple of institutional investors, among them in order to strengthen the board of directors: They decided to cosponsor a new institution which would locate, train and advise the non-executive directors. [21] The simple but bold mission was to promote the non-executive director to British companies seeking to strengthen boards. The new institution was given a modern name: PRO-NED. [22] It is to be noted that this scheme was not supported by private sector investment, or even any codified law.

The Bank of England gave responsibility of getting the new initiative off the ground to two main people: Jonathan Charkham, the then adviser to the Governor, was appointed as the Director of PRO NED; [23] and Sir Adrian Cadbury, one of their own Directors, was appointed to serve as Chairman. The two constituted a supportive and long lasting partnership which had a deep influence upon governance in the UK and beyond. [24]

Jonathan Charkham arranged personal meetings with the Chairmen of about thirty leading corporations as he believed that direct action was the best approach to initiate his task. After a number of meetings he finally selected a group of senior people willing and competent to serve. The subsequent concern was to provide some professional advice on what they would be required to do once they arrived on the board of a company, especially one where they were not appointed to play the role of an executive. This was in an atmosphere where normally the non-executive director would be appointed because of their links with government or other business but the challenge now to be faced was how to ensure this new group of independent director could be effective in endorsing enterprise and ensuring credibility.

Since the establishment of PRO-NED, the debate on the role of non-executive directors has both intensified and widened. In an analysis of the quality of the British boardroom, Sir Derek Higgs, commented gloomily that weakness originates from being too “male, pale and stale” adding sarcastically that as he fitted in all three categories he felt eligible to comment. [25] The Higgs Report encouraged a new round of thinking, the one which revealed another aspect to the question of employing independent directors:

“Independence defined as what you are not, through business or commercial relationships, as to independence defined as what you could be, namely one who was willing and able to challenge, and be objective in the face of conflicts of interest and professional loyalties.” [26] Evidently independent directors still have great problem in accepting this. The lack of ability to say ‘no’ on soaring pay is just one example in the US.

The role of the independent director requires depth of understanding, close relationships and business acumen and not just social contract or a financial network in the city. Moreover, the willingness to challenge conventional astuteness, question assumptions, evaluate propositions, and to be able to just say no, are few other qualities to effectively fulfil the role of the non-executive director. [27]

Research has shown evidence that the boardrooms where the directors share the same social and educational background, the probability of removing a failing CEO is less. France provides a good example of such boardrooms. [28] Perhaps the lack of ability to break the ties that bind could even lead to corporate collapses or under-performance. [29] Over the years concerns have been raised at the way the directors of some companies have apparently pursued their own self-interests often overlooking value creation for shareholders (for example, costly takeovers and mergers, ‘‘excessive’’ remuneration etc.). These concerns have led the financial authorities and the government commissioning several reports on corporate affairs which has consequently led to the emergence of a number of Codes of good Corporate Governance practice in the UK: (Cadbury Committee, 1992; Greenbury Committee Report, 1995; Hampel, 1998; Turnbull Report, 1999).

Board composition

The companies in Britain and the USA are characterised by unitary boards (where every director has an equal responsibility). However, the board’s constitution may vary depending on the type of business like American boards and financial companies usually have a majority of independent directors. This proportion had not been adopted by UK industrial companies earlier. [30] However, as a result of the corporate scandals in the early nineties and the subsequent issue of the “Codes of Best Practice”, the corporate governance state of affairs has improved significantly for eg. Lot of emphasis has been put on the importance of the non-executives independent monitoring role. [31] Particularly, the number of non-executives gradually increased over time so that by the end of the decade the proportion of non-executives to executives was equal number within the FTSE 350; and for companies outside the FTSE 350, presence of at least two non-executive directors is made mandatory [32] , whereas before and up to the early nineties, UK boards were had high presence of executive directors only. [33] This may be mainly fascinating considering the information published in the Higgs Report (2003, P.30, 10.5):

“A high level of informality surrounds the process of appointing non-executive directors. Almost half of the non-executive directors surveyed for the Review, were recruited to their role through personal contacts or friendships. Only four per cent had a formal interview and one per cent had obtained the job through answering an advertisement […]”. [34]

Earlier studies of the actual constitution of board membership posed that, the non-executive directors were more often than not closely “associated” with the Chief Executive. [35] The significant minority were the provider of services to the company on whose boards they sat. Naturally there interest lied in keeping the goodwill of the President (i.e .the Chief Executive) who had the power to decide whether to remove or keep their bank or lawyers’ firm serving a large and powerful corporation. [36] Most of the other non-executive directors were psychologically bound to the Chief Executive by friendship or as former colleagues. Even if there was no economic or psychological dependence, it was generally acknowledged that in reality, though not in law, the Chief Executive did not only bring them on to the board as a non-executive director, but could also get rid of them. The inference could be that the independence of monitoring action by English non-executives may be distorted and as Hart (1995) construes, only “quiet non-executives” are appointed by the corporations. [37] As Myles Mace [38] concluded from his study:

Also communicated to, and generally accepted by, directors was the fact that the president possessed the complete powers of control. Those members of the board who elected to challenge the president’s powers of control were advised, usually outside board meetings, that such conduct was inappropriate—or they were asked to resign. [39]

In strict law of course, the President of an American corporation does not have authority to remove a director from the Board, any more than does his British counterpart.

The decade of the 2000s has been the basis of a wide collection of interesting and largely horrifying case studies in Corporate Governance. [40] It started out with a sudden rash of corporate scandals the likes of which had never been expected: Enron, WorldCom, and Global Crossing in the U.S.; HIH and One Tel in Australia; Parmalat in Italy; Vivendi in France; and Royal Ahold in the Netherlands were among the famous international enterprises to be swallowed up in scandal and wrongdoing in just a few years’ time. [41]

It won’t be incorrect to say that most of these companies fell into tough times, only to realize that their non-executive directors were ignorant by their absence from the problems of the company. [42]

Enron Collapse: The last straw that broke the camel’s back…

The United States was surrounded by a wave of corporate scandals between late 2001 and the end of 2002. A lot of public corporations reiterated their financial statements, scores were brought to court by the Securities and Exchange Commission (SEC), and a number of executives were criminally prosecuted. But only two scandals stood out as big as they did: Enron and WorldCom. Because they were bigger in scale (leading to two biggest bankruptcies in U.S. history), [43] and as their failures exposed a strikingly complete breakdown in systems of internal and external monitoring as well as control, the dual collapse within a gap of few months from each other left the capital markets unstable, the reliability of U.S. financial reporting was belittled, and swift and aggravated punishing political reforms. [44] The impact of their collapse was experience not only in the United States but in many other places, including the United Kingdom. Subsequent to the Enron and WorldCom scandals in the US, the Combined Code was restructured in 2003 to incorporate recommendations on the role of non-executive directors from the Higgs Report and the associated Tyson Report. [45]

Enron and WorldCom were complicated financial shams in which the most important goal was to maximize the company’s stock price. Self-dealing was extant but it was not the fundamental motive for misconduct. The driving force behind the main actors in these two scandals was an ardent desire to maximize the corporation’s stock price by any means, sometimes by manipulating the earnings, sometimes by postponing expenses, sometimes by concealing liabilities or pursuing bizarre off-balance sheet dealings. However, success in this endeavour was dependent upon the support, or at least the acquiescence, of the corporation’s auditors and its other professional watchdogs such as the NEDs. Therefore, the main mystery turns out to be: Why did the watchdogs not bark? [46]

And because they did not bark, the United States’ much touted system of corporate governance was suddenly exposed. Warning signals had not simply been overlooked; rather, the sentinels upon whom the stakeholders relied seemed to have wilfully closed their eyes. [47] Especially in Enron’s case, it was as if the guards on the Titanic suddenly discovered the iceberg- and then jointly assumed it was not there.

The conduct of the Higgs Review…

After a period of calm in the media and popular interest in corporate governance issues (Jones and Pollitt, 2002), the topic has once again become fiercely controversial. [48] This renewed interest developed in 2001 after a series of high profile scandals (such as Enron) of large US based corporations in which poor corporate governance seemed to be a noticeable element. The lack of public trust in corporations and the intention of governments to be seen to take action caused pressure for a review, if only to check in the UK that all measures had been observed to reduce the risk of the same crisis happening here. [49]

In the middle of 2002, the US government adopted swift actions via the Sarabanes-Oxley Act [50] as well as both the NYSE and Nasdaq made it mandatory for listed corporations to have a majority of independent directors and that certain crucial board committees (such as Audit committee) be composed of independent directors entirely. Additionally, the definition of ‘independence’ for independent directors was re-evaluated and tightened in nature. In this situation the UK Government also reacted promptly to head-off any likely consequences of US regulation and legislation for companies of British origin that are listed on the NYSE. [51] The basis of the UK response to the corporate governance outcome from the US was to establish an independent review to be led by Derek Higgs – of the role and effectiveness of non-executive directors. [52] This was initiated by the Secretary of State for Trade and Industry and the Chancellor, in April 2002. [53] Higgs reckoned that the earlier scandals, which led to the Cadbury Report, could have been averted had a Code been in place. He believed that the Robert Maxwell fiasco could also have been avoided as many firms had already refused any dealings with him and revelation of his corporation’s governance practices would have led to increased pressure for change.

Evolution of Non Executive Director’s Role

There is no specific difference between the standard of care that non-executive directors must take in comparison to other directors and even though they may not spend the same amount of time handling the company’s business like the executive directors, the level of commitment expected out of them is no less. All the decisions made by all the directors must be in the best interests of the company.

The duties of directors have certainly evolved over the years, as the courts have interpreted the legislation regulating UK companies. Consequently, all directors must display due skill, caution and good faith in discharging fiduciary obligations.

The Companies Act 2006 has placed new statutory duties on executive and non-executive directors alike. According to the Companies Act 2006 (Sec. 171 to 177) all directors have:

a duty to act within powers set out in the company’s memorandum of association,

a duty to promote success of the company,

a duty to exercise independent judgement,

a duty to exercise reasonable care, skill and diligence,

a duty to avoid conflicts of interest,

a duty not to accept benefits from third parties, and

a duty to declare interests in proposed transactions or arrangements.

The general duties of all directors (Sec. 170 to 181) came into force on 1 October 2007 and duty to avoid conflicts of interest, duty not to accept benefits from third parties and duty to declare interest in proposed transaction or arrangement (Sec. 175 to 177) came into force on 1 October 2008. [54]

Renewed Liabilities

Even though non-executive directors are not liable for a company’s everyday management, but they have the same legal duties as executive directors, they are equally liable to be disqualified under the Company Directors Disqualification Act, 1986. If a company’s board of directors is enquired for ‘misconduct or wrong doing’, then such an enquiry will be inclusive of the actions or omissions of non-executive directors.

Generally, a director can be disqualified for common misconduct in relation with companies or for being unsuitable to act as company director. The maximum period for disqualification extends to 15 years, nevertheless, as seen in a number of cases the courts may exercise their discretion and apply a lesser period of disqualification in acknowledgment of the role and relative duties of a non-executive director.

The behaviours and personal attributes of the effective non-executive director

The Combined Code on Corporate Governance, issued in 2006 and 2008, gives some practical guidance specifically to non-executive directors, stating that:

“As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors, and in succession planning.” [55]

Obstacles faced by the Non-Executive Directors in effectively monitoring the management of the company:

The increased managerial pressure. [56] Rapid changes in executive compensation generally makes corporate managers far more interested in maximizing the firm’s short-term profits- without taking into consideration whether the resulting stock price spike could be sustained for long or not. Thus incentivized, corporate managers find ways to pressure or seduce their gatekeepers which includes the NEDs into acquiescence in increasingly riskier accounting policies; and

The stock market bubble. [57] During a bubble, investors tend to lose their scepticism, and may come to expect stock prices to soar annually. In this environment of market euphoria, the gatekeepers such as the NEDs become irrelevant- or, even worse, shareholders reinforce the pressure on them for the use of risky and/ or unacceptable accounting policies in order to maintain inflated earnings growth. Caught between the pressure of executives and stockholders for relentlessly increasing profits, NEDs are not left with much option but to tell their audience what they want to hear.

Conclusion:

In the past there was a clear balance of power in favour of the executives, particularly the Chief Executive which gave non-executives the status of mere spectators of the company’s performance. But now there is much evidence to suggest these practices are now changing, and that independent non-executives practice greater influence upon company direction. The move in favour of independent directors, which was initiated as a “good governance” buzz word, has become in some respects a mandatory element of corporate law.

Post-Enron federal laws require public companies to have an audit committee comprised exclusively of independent directors. In law there is no difference between non executive directors and executive directors and the Companies Act merely mentions “directors” who are all equally responsible and to an extent liable, for the company’s actions. In addressing the post Higgs governance guidelines on the majority of directors being non executive / independent it seems that the balance has shifted so far that the executive directors are approaching the era where they’ll end up as a small minority in the larger companies.

In the end, it must be understood that the executive directors are captives of their gatekeepers, the Non Executive Directors. No board of directors – no matter how competent and loyal its members – can surpass its professional advisors. Only if the board’s agents properly monitor, advise and warn it, can the board function effectively.