The Higgs Report on Non-Executive Directors and the Smith Report on Audit Committees - substantial changes in corporate governance best practice
20 January 2003 saw the publication of both Derek Higgs' "Review of the role and effectiveness of non-executive directors" and the Financial Reporting Council's new guidance for audit committees, produced by a group chaired by Sir Robert Smith.
They constitute a significant overhaul of best practice in corporate governance. The new requirements, particularly those on the composition of boards and audit committees, will have a major impact on all UK listed companies.
The Higgs Report
The Higgs Report can be obtained from www.dti.gov.uk/cld/non_exec_review. The Higgs Report rejects the imposition of change by law or regulation and instead proposes a revised Combined Code and continuing with the "comply or explain" principle. The suggested new Code principles and provisions are discussed in the main text of the report (references in brackets below are to the relevant sections of the Higgs Report).
The FRC is inviting "fatal flaw" and drafting comments on the draft Code by 14 April, and will issue the final version to come into effect on 1 July. It is not yet clear whether there might be a transitional period for the "comply or explain" requirement for the new Code, or whether it will be in place in full for the 2004 annual report season.
The report also makes a number of best practice recommendations, which will not form part of the Code. These are collected together in Annex B.
The biggest change is a new Combined Code provision that at least half of the members of the board, excluding the chairman, should be independent non-executive directors (9.5). This will involve a huge shake-up. Recent research by PIRC suggests that independent directors are in a majority on less than 20% of the boards it analysed. The report emphasises that the practical implications of this mean that it will take some time to achieve. However, listed companies will still have to explain whether they meet the board composition requirements and, if not, what steps they are taking to do so.
The other side of the coin is that it is not desirable to have a very small number of executive directors - that leads to a greater risk of distortion or withholding of information, or lack of balance in the management contribution to boardroom debate. The amended Code will therefore provide that there should be strong executive representation on the board (8.6).
Then the final part of the equation is that there is also to be a new Code provision to the effect that board sizes should not be so large as to become unwieldy (4.10) - so simply appointing a whole raft of new non-executives won't work.
All of this means that there will be no sudden change and that companies will have to just gradually adjust the board balance over a number of years.
Role of the board
There was some speculation last year that the report might call for "two-tier" boards. In fact, it endorses the unitary board.
Higgs has, however, added a new Code provision that the non-executive directors should meet on their own at least once a year, and there should be a statement in the annual report on whether they have done so (8.8).
The Combined Code will contain an expanded statement on the role of the board (Chapter 4). This emphasises both its entrepreneurial role and its ethical responsibilities - to set the company's values and standards and ensure that its bligations to shareholders and others are understood and met.
In addition, individual boards should publish in their annual report a description of how the board operates, including a statement of which decisions are taken by the board and which are delegated, and stating the number of meetings of the board and each board committee and attendance by individual directors (4.8).
Role of the chairman
The report suggests substantial changes in best practice in relation to the role and independence of the chairman. It takes a more robust stance than the existing Code on separating the roles of chairman and chief executive - a clear statement that the roles should be separated (5.3).
Augmenting this is a new Code provision that the division of responsibilities between the chairman and chief executive should be set out in writing and agreed by the board (5.5). The guidance on the chairman's role and responsibilities (Annex D) will help in doing this.
The new Code will also say that a chief executive should not become chairman of the same company (5.7). This has previously been regarded as a tricky issue, but not one where there was a clear-cut view, and there are some recent high-profile examples of a chief executive moving on to become chairman. Finally, there is a new Code provision on the application of the independence criteria to the chairman. At the time of appointment the chairman should meet the test of independence (see below), but it is not appropriate or necessary for him to do so once he has been installed in his role (5.8).
The role of the non-executive director
A new provision in the Combined Code will give some guidance, for the first time, on the role of the non-executive director. This is fourfold: to challenge and contribute to strategy; to scrutinise the performance of management; to assess the accuracy of financial information and the robustness of risk management systems; and to determine levels of executive remuneration and play a key part in executive appointments, removals and succession planning (Chapter 6).
The report focuses on the behaviours and personal attributes that make a non-executive director effective. Critics of UK plc's corporate governance have suggested that whilst corporate governance initiatives may prescribe structures and systems, truly effective protection lies in the calibre of the individuals involved. The report describes the relevant qualities: integrity and high ethical standards; sound judgement; the ability and willingness to challenge and probe; and strong interpersonal skills (Chapter 6, and the guidance for non-executive directors at Annex C).
Senior independent director
Higgs endorses the appointment of a senior independent director, which was one of the more controversial innovations in the original Combined Code.
What is new is the proposed Code provision which will say that the main role of the appointee will be to act as a separate channel for shareholders (7.5). The senior independent director should be available to shareholders who have concerns that have not been resolved through contact with the chairman or chief executive, or which are inappropriate to raise with them. Initial reactions have been that this could lead to boardroom splits; only time will tell whether that will be the case.
Another new Code provision will make it the senior independent director's responsibility to attend "sufficient of the regular meetings of management with a range of major shareholders to develop a balanced understanding of the themes, issues and concerns of shareholders" (15.15).
Whilst focusing on the technical concept of "independence", the report does point out that all non-executive directors and indeed all executive directors need to be independent in the sense of being independent of mind and willing and able to question, challenge and speak up.
For the first time, there will be some guidance in the Combined Code itself on the meaning of "independence" in the stricter sense, as it is to be applied to independent non-executive directors (see inset box for the new definition). There are currently over a dozen such definitions in the UK, despite the attempts of the ABI and NAPF who published a joint statement of guidance in 1999 which they hoped would be definitive. It will be interesting to see whether the various shareholder bodies do indeed drop or amend their own criteria for assessing independence.
A non-executive director is considered independent when the board determines that the director is independent in character and judgement and there are no relationships or circumstances which could affect, or appear to affect, the director's judgement. Such relationships or circumstances would include where the director:
ï is a former employee of the company or group until five years after employment (or any other material connection) has ended;
ï has, or has had within the last three years, a...