1. INTRODUCTION ...... 1 2. CORPORATE GOVERNANCE DEFINED ...... 1 3. EVOLUTION OF CORPORATE GOVERNANCE IN THE UK...... 2 4. THE COMBINED CODE ...... 2 4.1 Section 1 Companies ...... 3 4.1.1 Directors ...... 3 4.1.2 Directors’ Remuneration...... 3 4.1.3 Relations with Shareholders...... 4 4.1.4 Accountability and Audit ...... 4 4.2 Section 2 Institutional Shareholders...... 5 4.2.1 Institutional Investors...... 5 5. THE POWER OF COMPLY-OR-EXPLAIN ...... 5 6. PROPOSED UK REFORMS ...... 6 6.1 Higgs Report ...... 6 6.2 Smith Report...... 8 6.3 Secretary of State for Trade and Industry Comments ...... 9 6.4 Law Commission ...... 9 7. CRITIQUE OF PROPOSED REFORMS...... 11 7.1 The Higgs Report: Discussion...... 11 At Least Half of the Board Should be Independent NEDs...... 12 Refined Definition of Independence...... 12 Separation of the Roles of CEO/Chairman...... 13 Nomination Committee Chair to be Independent NED, not the Chairman ...... 13 Expansion of the SID’s Responsibilities ...... 14 Separate NED Meetings ...... 14 Remuneration ...... 15 7.2 The Smith Report: Discussion...... 15 Duties Related to External Auditors: Non-Audit Services ...... 15 Financial Expert on the Audit Committee...... 16 8. COMPARISON HIGHLIGHTS WITH US REFORMS ...... 16 9. CONCLUSION...... 19 Corporate Governance: UK Proposals and US Comparisons 17 April 2003 by Sarah La Voi & Peter Borrowdale
1. INTRODUCTION
Recent public company crashes in the US and the UK have left a devastating wake.
Regulators across the globe are setting reforms in motion to improve standards of corporate governance in public listed companies with the aim of protecting against a recurrence of Enron, Worldcom, or Maxwell–style company breakdowns. While reforms to corporate governance procedures are inevitable, members of the business community must monitor proposed changes and consider their practical effects to ensure that the sound, flexible UK approach to corporate governance is not lost.
This report will first discuss corporate governance generally, outlining the course of UK Corporate Governance evolution. Next, this report will raise the key points of emerging UK corporate governance reforms, discussing the benefits, criticisms, and implications of each. Pushing further, it will also consider the comparative issues, analysing similarities and differences in UK and US trends and how specific proposed rules may impact business.
2. CORPORATE GOVERNANCE DEFINED
In its narrowest sense, corporate governance deals with the manner in which a corporation is controlled and directed. To define corporate governance, it may be necessary first to clarify what it is not. Corporate governance is distinct from the notion of "corporate social responsibility", yet people often confuse the two concepts. Corporate social responsibility pertains to a corporation's implied, external duties to society as a whole, including for example public safety and environmental concerns. Alternatively, corporate governance deals with the internal control and direction of public listed companies only.
In the wake of high profile corporate collapses, the modern commercial climate demands expansion and clarification of these principles for listed companies and, perhaps, more prescriptive best practices. Thus corporate governance across the globe is in a process of re-definition. Earlier UK models of corporate governance laid down general principles to steer corporations away from fraud, mismanagement, and lax administration. Reformed corporate governance models will encompass the broader issues of improving shareholder returns while employing ethical, transparent management practices that promote accountability and fairness. To achieve this goal, UK corporate governance ideology could shift towards a more proscriptive, rules-based approach. Secretary of State Patricia Hewitt vehemently denies that UK corporate governance will evolve into an exercise in box ticking. This forecast has divided the UK business community into different camps; each sees the destination of improved corporate governance yet all have different ideas on the best route there.
3. EVOLUTION OF CORPORATE GOVERNANCE IN THE UK
2 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 The UK has pioneered corporate governance reforms for over a decade, constructing an episodical framework that will shape future reforms. Spurred by the Maxwell pension scandal in the 1990s, the government commissioned researchers to investigate UK corporate governance standards and to propose ways to reinforce the system. Foundations laid by the 1992 Cadbury report, the 1995 Greenbury report, and the 1998 Hampel report resulted in the Combined Code Principles of Good Governance and Code of Best Practice (Combined Code). The Code, which applies to UK listed companies, sets out the widely accepted "comply-or-explain" doctrine of corporate governance that promotes transparency, accountability, fairness, and responsibility. Companies listed on the London Stock Exchange's Alternative Investment Market (AIM) are not required to comply with the Combined Code, yet adherence is encouraged.
The recent Higgs and Smith reports aim to develop the Combined Code even further, calling for non-executive directors to take on more corporate leadership responsibility and to monitor keenly auditor activities. The Department of Trade and Industry (DTI) initially commended both the Higgs and the Smith reports and, after compromising certain recommendations, will probably support their incorporation into the Combined Code. The DTI has also announced plans beyond Higgs and Smith to restructure the UK accountancy profession and to implement a major overhaul of UK regulatory body structures and responsibilities, which will take effect immediately.
Heavy-handed amendments to the non-legally binding Combined Code are not the end of proposed UK reforms; legislative action may also be on the horizon. The UK Law Commission has proposed drafting a statutory statement of directors' duties and amending Part X of the Companies Act (Enforcement of Fair Dealing with Directors) to reflect stricter corporate governance standards. The Department of Trade and Industry's Steering Group issued the Company Law Review in 1999 which supports the Law Commission's position on corporate governance reforms. The Company Law Review, officially entitled Modern Company Law for a Competitive Economy: the Strategic Framework, assessed core company law and advocated reinforcement and clarification of the law with respect to directors' duties. Further, the report pointed to the Law Commission's recommendations to draft legislation in the area of directors' duties.
4. THE COMBINED CODE
In its current form, the Combined Code regarding companies establishes the principles of good governance laid out below. The full Combined Code1 also lays out detailed best practice guidelines. If public listed companies do not comply with the code, they must publicly explain the deviation.
The Combined Code Principles of Good Governance (May 2000)
4.1 Section 1 Companies
4.1.1 Directors
1 The full Combined Code in its current form includes the preamble and the code of best practice. It will likely change by July 2003, yet the current version (from April 2003) is available at http://www.fsa.gov.uk/pubs/ukla/lr_comcode.pdf.
3 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 The Board
Every listed company should be headed by an effective board which should lead and control the company.
Chairman and CEO
There are two key tasks at the top of every public company - the running of the board and the executive responsibility for the running of the company’s business. There should be a clear division of responsibilities at the head of the company which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision.
Board Balance
The board should include a balance of executive and non-executive directors (including independent non-executives) such that no individual or small group of individuals can dominate the board’s decision taking.
Supply of Information
The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties.
Appointments to the Board
There should be a formal and transparent procedure for the appointment of new directors to the board.
Re-election
All directors should be required to submit themselves for re-election at regular intervals and at least every three years.
4.1.2 Directors’ Remuneration
The Level and Make-up of Remuneration
Levels of remuneration should be sufficient to attract and retain the directors needed to run the company successfully, but companies should avoid paying more than is necessary for this purpose. A proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance.
Procedure
Companies should establish a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration.
Disclosure
The company’s annual report should contain a statement of remuneration policy and details of the remuneration of each director.
4 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 4.1.3 Relations with Shareholders
Dialogue with Institutional Shareholders
Companies should be ready, where practicable, to enter into a dialogue with institutional shareholders based on the mutual understanding of objectives.
Constructive Use of the AGM.
Boards should use the AGM to communicate with private investors and encourage their participation.
4.1.4 Accountability and Audit
Financial Reporting
The board should present a balanced and understandable assessment of the company’s position and prospects.
Internal Control
The board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.
Audit Committee and Auditors
The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company’s auditors.
4.2 Section 2 Institutional Shareholders
4.2.1 Institutional Investors
Shareholder Voting
Institutional shareholders have a responsibility to make considered use of their votes.
Dialogue with Companies
Institutional shareholders should be ready, where practicable, to enter into a dialogue with companies based on the mutual understanding of objectives.
Evaluation of Governance Disclosures
When evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional investors should give due weight to all relevant factors drawn to their attention.
5. THE POWER OF COMPLY-OR-EXPLAIN
5 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 This doctrine can be an extremely effective tool, if used correctly. UK corporate governance models are built on the premise that one size does not fit all; companies, like people, have distinct personalities that require different approaches.
Yet, for the doctrine of comply-or-explain to work as it was intended, both public companies and their shareholders must actively play their parts. For example, if a strong, well-performing company chooses to defy Higgs’ recommendations and continue, for example, with a joint CEO/Chairman, it may do so – with a thorough explanation. Higgs encourages companies to take the route that is best for them, if shareholders are adequately advised. Shareholders should weigh the company’s explanations and decide whether these deviations from the Combined Code are justified.2 Yet some critics claim that large institutional shareholders striving for simplicity and efficiency wish to tick boxes as opposed to exploring the benefits of the road less travelled. They say institutional investors balance a thick portfolio and staying on top of several companies’ deviations may be too burdensome.
This apathetic, time-driven shareholder attitude, if true, could cause conflicts with the British model of corporate governance, which allows companies to make their own decisions, as opposed to strapping them to mandatory regulations. Comply-or- explain allows companies the flexibility to explain why deviations from the listed best practice procedures may be best for their particular situation, resulting in higher profits for their shareholders. To benefit from this respectful leeway, companies have to have the courage to deviate from the Combined Code and shareholders must take the precious time to listen and approve, where appropriate.
Many listed companies may be tempted to rush into compliance with the revised Combined Code, after the incorporation of the Higgs and Smith Reports, to placate shareholders, regulators, and the media. Yet, advisors should carefully consider the pros and cons of blind compliance. One must first asses the industry, the company culture and performance, as well as the shareholder climate when pondering a deviation. There is a strong temptation to advise clients to comply. Yet, if companies choose to comply too hastily, and deviations become increasingly rare and therefore subject to intense scrutiny, it will become less acceptable to deviate in the future. Therefore, we may effectively lose the right to deviate. Thus, even though corporate governance compliance is very much in vogue, UK companies must not forget that they still have the power of the comply-or-explain doctrine. On the other side of the Atlantic, Sarbanes-Oxley reforms have not afforded US companies this respect or flexibility. US companies who deviate from corporate governance reforms are in breach of securities regulations. In the UK, we must use this right of flexibility effectively to preserve it.
6. PROPOSED UK REFORMS
Listed below are key points contained in four different sets of UK corporate governance proposed reforms set out by: (1) the Higgs report, (2) the Smith report, (3) the Secretary of State for Trade and Industry, and (4) the Law Commission proposals. Several points contained in each will probably take effect before the end of 2003. A thorough discussion of the benefits, criticisms, and implications of several of these proposals is discussed in Section 7.
2 The Combined Code states in its Principles Section that institutional shareholders shouldn give due weight to all governance disclosures.
6 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 6.1 Higgs Report
Focus: Review of the role and effectiveness of non-executive directors
The Higgs report lays out best practice for board construction and suggests methods and behaviours to procure the right people to fill non-executive positions. Generally, Higgs advocates that non-executive directors be more actively involved in corporate oversight by asking tough questions and demanding honest answers. Initially, Higgs' recommendations received a warm welcome in the UK, yet opposition to some points has gained momentum. Key Higgs recommendations include:
Board Make-up: The majority of the board should be comprised of non-executive independent directors (Independent NEDs).
Committee Make-up: All members of the audit and remuneration committees should be independent, as should a majority of the nomination committee. Further, an Independent NED, not the chairman, should chair the nomination committee.
Refined Definition of Independence : Higgs recommends raising the bar to meet the test for independence. The new proposed definition states that a non-executive director is considered independent if he is "independent in character and judgement and there are no relationships or circumstances which could affect, or appear to affect, the director's judgement."
Prohibition of joint CEO/Chairman: These roles must be distinct, separate, and held by two different individuals. The chairman must be independent at the time of appointment and a chief executive should not later become chairman of the same company after stepping down.
Senior Independent Director: The current Combined Code already suggests appointing a Senior Independent Director (SID), yet Higgs plans to increase the SID’s responsibilities. Higgs suggests that companies expand the role of the SID so that he be available to shareholders if concerns have not been addressed through normal channels of communication with the chairman or chief executive.
Separate NED meetings: Non-executive directors should meet without the chairman or the executive directors at least once a year. These meetings are to be chaired by the SID.
Nomination Committee: The board nomination committee should contain over one- half Independent NEDs and be chaired by an independent. Higgs also recommends actions to broaden the qualified candidate pool of Independent NEDs by tapping both private companies and the public sector and by actively seeking out qualified women and international candidates. Laura Tyson, of the London Business School, leads a government committee aiming to develop procedures that will help companies recruit qualified independent non-executive director candidates from the non-commercial sector.
Investigation and Induction: Prior to appointment, new non-executive directors should carry out due diligence of the board and the company to establish their own suitability for the role. Following appointment, all new non-executive appointees should go through a formal induction process to familiarise themselves with the board, the company, and their new roles. This process allows new non-executives to assess their own capabilities in light of the job's requirements.
7 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 Tenure: The standard tenure for a non-executive director should be two three-year terms. Longer terms will be accepted occasionally, if for good reason.
Limits on Directorships: A full-time executive should not take on more than one non-executive directorship nor should he become chairman of a major company. Individuals should not chair the board of more than one major company simultaneously.
Remuneration for Non-Executives: The remuneration committee should consist entirely of Independent NEDs. Remuneration for non-executives should be adequate to attract and fairly compensate high quality individuals; additional compensation for chairmanship of the board or of committees is acceptable. Non-executive compensation may be in the form of an annual fee or in the form of shares. Exceptionally, if a portion of compensation is paid in options (1) the board must seek prior shareholder approval and (2) any shares obtained by exercising the options should be held until one year after the non-executive leaves the board.
6.2 Smith Report
Focus: Independence of Audit Committees
Higgs, like Smith, has suggested aggressive reforms. Below are some highlights from the Smith report recommendations:
Audit Committee Make-up: Audit committees should consist entirely of independent members and the company chairman should not be an audit committee member.
Required Skills and Training: On the audit committee, there must be at least one member having relevant financial experience. Quoting the Smith report: "At least one member of the audit committee should have significant, recent and relevant financial experience, for example as an auditor or a finance director of a listed company." Further, all audit committee members should receive a formal induction that includes introduction to some company staff, major shareholders, and regular, ongoing refresher training.
General Duties: The audit committee should monitor the integrity of the company financial statements, review internal financial control systems and if necessary, risk management systems, and monitor and review the effectiveness of the company's internal audit function. Note that it is still management's, not the audit committee's, primary responsibility to produce accurate, compliant, financial statements.
Duties Related to External Auditors: The audit committee should make recommendations to the board regarding appointment of the external auditor and approve related remuneration and terms of engagement, confirm that external auditors rotate in accordance with UK guidelines,3 ensure the external auditor is
3 There is no regulatory requirement for UK listed companies to change auditors after a number of years in office. However, where the same audit engagement partner acts for an audit client for a prolonged period, a familiarity threat is recognised as arising. As a result, the UK regulatory requirements are that, for listed companies, the audit engagement partner cannot act for more than seven years and cannot return to that role for a further five years. This is taken from the Executive Summary of 'Mandatory rotation of audit firms' - A July 2002 report by the Institute of Charter Accountants of England and Wales available at http://www.icaew.co.uk/publicassets/00/00/03/64/0000036465.PDF.
8 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 independent, objective, and effective, and develop and implement policy regarding the external auditor's supply of non-audit services. When evaluating whether an auditor should provide non-audit services, Smith lays out principles to guide audit committees: An audit firm should provide no non-audit services if (1) the external auditor audits its own firm's work; (2) the external auditor makes management decisions for the company, (3) a mutuality of interest is created; or (4) the external advocate assumes the role of company advocate.
Meetings of the Audit Committee: At minimum, there should be three meetings yearly, yet most audit committee chairmen will call more. Only members of the audit committee are entitled to attend the meetings; however, others may be invited to attend. It is expected that regular invitations will be extended to the external audit lead partner and to the finance director. At least yearly, the Audit Committee should meet with the external auditor, without management, to discuss issues arising from the audit.
Audit Committees Seeking Independent Counsel: the Smith report recommends that audit committees receive funds to seek independent counsel when the committee reasonably believes it to be necessary.
Conflict of Views: The audit committee should report to the board when it is displeased with any aspect of the proposed financial reporting.
Whistleblowing: The audit committee should ensure that schemes are in place by which staff may confidentially raise relevant concerns.
6.3 Secretary of State for Trade and Industry Comments
In January 2003, Secretary of State Patricia Hewitt made a statement to the House of Commons endorsing both the Higgs and the Smith reports. Beyond Higgs and Smith, Secretary of State Hewitt announced reforms to the accountancy profession and a major overhaul of UK regulatory body structures and responsibilities, to take effect immediately. Namely, the Financial Reporting Council (FRC) will assume the functions of the Accountancy Foundation, creating a unified, independent UK regulator with three clear roles:
1. Setting accounting and audit standards; 2. Pro-actively enforcing and monitoring them; and 3. Overseeing the self-regulatory professional bodies.
Secretary of State Hewitt also announced these specific structural changes:
1. The Auditing Practices Board, not the professional bodies, will now set the standards for independence, objectivity, and integrity;
2. The Ethics Standards Boards will be wound up and a new professional oversight board will be formed to oversee ethical standards;
3. A new independent investigation unit, within the FRC, will inherit responsibility from the professional bodies for monitoring audits of listed companies, major charities, and pensions; and
4. An investigation and discipline board shall be formed to provide an independent forum for hearing public interest disciplinary cases.
9 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 Secretary of State Hewitt acknowledged that statutory revisions may be necessary to make these structural reforms work.
6.4 Law Commission
In September of 1998, the Law Commission issued a report entitled Company Directors: Regulating Conflicts of Interests and Formulating a Statement of Duties. Divided into two sections, the report dealt first with proposed amendments to Part X of the Companies Act 1985 and second with drafting legislation to clarify directors’ duties.
6.4.1 Regulating Conflicts of Interests through Statutory Amendment: Summarising the report, the Law Commission recommends the retention of most of Part X of the Companies Act 1985 yet proposes to repeal sections 311, 318(5) and (11), 323, and 327.4 In detail, the Law Commission supports the following changes:
(a) Increased disclosure in a company's annual accounts regarding compensation paid to individual directors for loss of office;
(b) Limiting the interests (those which require disclosure) a director may acquire and introducing civil remedies for non-disclosure;
(c) Reducing from five to three years the time period of a director's service contract that requires shareholder approval and extending statutory control to rolling contracts;
(d) Amending section 320 to allow a company to agree a substantial property transaction with a director by contract which is conditional on the company first obtaining shareholder approval;
(e) Extending loan prohibitions in sections 330-337 to all companies while retaining the existing exemptions from prohibitions;
(f) The repeal of sections 311, 318 (5) and (11), 323 and 327;5
(g) The introduction of a coherent code of civil remedies for Part X – in general, when Part X sets out a prohibition or restriction, the consequences of that breach should also be outlined in one coherent section.
6.4.2 Drafting Legislation for Directors' Duties: In short, the report recommended formulating a statutory statement of duties owed by directors
4 Section 311 deals with prohibition on tax free payments to directors; section 318(5) provides an exception from the requirement that companies retain copies of directors’ contracts and their terms for directors working mainly outside of the UK; section 318(11) provides an exception from the requirement that companies retain copies of directors’ contracts and their terms if the contract is set to expire in less than 12 months or if the contract can be terminated without pay in the next ensuing 12 months; section 323 covers option dealings by directors; section 327 extends the prohibition in section 323 to spouses and minor children.
5 See Note 4 for explanation of these sections.
10 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 to companies. The statutory definition of a director's duty of skill and care would mirror the dual objective/subjective standard articulated in section 214(4) of the Insolvency Act 1986:
"… The facts which a director of a company ought to know or ascertain, the conclusions which he ought to reach and the steps which he ought to take are those which would be known or ascertained, or reached or taken, by a reasonably diligent person having both-
(a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and
(b) the general knowledge, skill and experience that the director has.
It should be note that the Directors' Remuneration Report Regulations 2002 came into force in August 2002 and amended Part VII (Accounts and Audit) of the Companies Act 1985 to introduce two new requirements for quoted companies:
? A duty to produce a directors’ remuneration report for each relevant financial year that:
- Contains the information required by the new Schedule 7A to the 1985 Act; and
- Complies with the requirements of the new Schedule 7A as to how that information is set out in the report
? A duty to hold a member’s vote on approval of that report at the company’s general meeting before which the company’s annual accounts for that financial year are laid (Section 241A, 1985 Act).
If the directors fail to comply with the new requirements they will be guilty of an offence under the 1985 Act and be liable to fines.
Schedule 7A states that the directors’ remuneration reports must now contain the following items: disclosures about remuneration policy; details of the remuneration committee; the performance graph; details of directors’ service contracts; and details of directors’ remuneration. Details of each director’s remuneration are subject to audit whereas the other matters are not subject to a similar audit.
7. CRITIQUE OF PROPOSED REFORMS
Of the proposed reforms, the Higgs Report has drawn the most fire within the UK business community, yet the Smith Report also proposes to change radically the manner in which companies manage their internal and external audits. This section will pinpoint topical suggested reforms in the Higgs and Smith Reports and discuss their implications.
7.1 The Higgs Report: Discussion
First, it is important to note that Derek Higgs has chosen to suggest revisions to the Combined Code only. He did not advocate drafting laws, as the Law Commission has, that would require absolute adherence to his recommended corporate
11 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 governance reforms. Yet, many in the business community disagree that Higgs’ proposals will, in reality, shore up corporate governance. Some believe his proposals could indeed inflict damage on boardroom control and morale.
At Least Half of the Board Should be Independent NEDs
Higgs’ primary recommendation is sweeping. He proposes that the company board be comprised of at least half independent NEDs, excluding the Chairman. To meet this requirement, company boards will necessarily increase in size. Companies are unlikely to remove their own executives from the board to meet the quota, which implies that more independent NEDs will have to be added if companies wish to be Higgs-compliant.
This potential size increase is problematic. A bigger board is not always a better board and flooding a boardroom with extra bodies to comply with the Combined Code could result in clumsy stewardship. Increasing the number of directors also necessitates an increase in the fees and overhead paid out by the company to accommodate the new appointees, which could reasonably trouble shareholders. This is an especially sensitive issue for smaller companies with less available resources.
The qualified candidate pool for independent NEDs is rather shallow, as Higgs himself has pointed out. The UK companies and business communities are concerned about from where these extra directors will come. Laura Tyson’s committee project to develop a list of qualified candidates from the untapped public and non-profit sectors was abandoned; now the committee will only draft suggested procedures for independent NED recruitment. Companies will be left to their own devices to unearth independent NEDs with relevant know-how and experience. Realistically, directors recently released from their posts at other companies will likely fill these seats. Currently, there are three incarnations of directors: (1) executive directors involved in management; (2) non-executive directors who do not meet the requirement for independence (non-independent NEDs), and (3) independent NEDs. If Higgs’ proposals are adopted, the second type of director, a non-independent NED, will become less valuable. Companies will, naturally, need their own management on the board and enough spaces for independent NEDs. This leaves the NEDs who may not meet the test for independence due to past business dealings or employment with the company in the lurch. Perhaps these redundant NEDs will play a game of corporate musical chairs, shifting to other public listed companies with whom they have no connections yet could benefit from their valuable business acumen.
Refined Definition of Independence
Higgs recommends raising the bar to meet the test for independence. The new proposed definition states that a non-executive director is considered independent if he is "independent in character and judgement and there are no relationships or circumstances which could affect, or appear to affect, the director's judgement." The current Combined Code does not eliminate candidates with relationships that could only appear to affect their independence of judgement.
A representative from the Financial Services Authority (FSA) has indicated in the media that this definition will require fine-tuning before it is incorporated into the Combined Code. Commentators have noted further that, even though solicitors for example would be excellent candidates for non-executive directorships due to their legal and commercial awareness and expertise, few are likely to fill these boardroom
12 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 seats. Higgs' stricter definition of independence makes it more difficult for solicitors and other professional advisors to serve as non-executive directors because any work they or their firms do or have done for the company would be seen as a potential conflict. The current Combined Code guidelines allow room for professional advisors to act as non-executive directors if they use care to separate their interests; Higgs’ proposed definition does not allow this compromise.
Separation of the Roles of CEO/Chairman
The current Combined Code recognises that there are two distinct jobs at the head of a public listed company, leading the board and managing the company, and requires a separation of these functions. Higgs takes this one step further to require that two separate individuals hold the CEO and Chairman posts.
Having a separate CEO and Chairman is standard practice in the UK and therefore there has been little vocal opposition to this recommendation. The Higgs report revealed that only 5 FTSE 100 companies have a joint CEO/Chairman, as opposed to the US where several high-profile corporations have one person running both the corporation and its board (e.g. McDonald's Corporation and General Electric).6
However, some members of the UK business community have objected to Higgs’ recommendation that company CEOs may not later serve as chairman of the same company. A retired CEO stepping into the chairman post is rather common. The Confederation of British Industry (CBI) released a survey of 61 public company chairmen in March of 2003 that indicated opinions are rather split on this proposition. Fifty percent of poll respondents either disagreed or strongly disagreed with this statement: "Disallowing a Chief Executive Officer to become Chairman of the same company will lead to better board performance." Thirty-nine percent agreed or strongly agreed with the statement (11% had no view on the matter).
Nomination Committee Chair to be Independent NED, not the Chairman
Higgs' recommendation that an independent NED (and not the company chairman) chair the nomination committee has prompted strong disapproval from the business community. The Confederation of British Industry (CBI) released a survey of 61 public company chairmen in March of 2003 that reported 87% of respondents strongly disagreed or disagreed with this statement: "The recommendation that the Nomination Committee should be chaired by an independent Non-Executive Director will strengthen the independence of the board". A CBI press release opined that disallowing the company chairman from chairing the nominations committee would run "counter to the drive to maintain a strong and unified board." Instead, according to the CBI, the board should resist any attempts by the chairman to recruit individuals on any basis besides merit, ability, and independence.
Higgs, in fact, has already made recommendations to ensure that the board will have the power to resist any attempts by the chairman to place underqualified individuals on the board. This is true even if the chairman chairs the nomination committee. Higgs has proposed that the majority of the nomination committee be comprised of
6 In this instance, UK proposals push further than US proposals. Sarbanes-Oxley does not require that separate individuals serve as Chairman and CEO.
13 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 independent NEDs. Therefore, even if the chairman steers the nomination process7 and exercises great weight in building the board, the rest of the committee has the numbers, independence and the authority to outvote the chairman when they deem it necessary. Further, final candidates must pass the vote of the entire board. These checks should be sufficient to guard against a heavy-handed chairman who heads the nomination committee; there is no need to take the next step of banning the chairman from chairing the nomination committee. It is also important to note that the chairman is a natural leader of the nomination committee due to his knowledge of and commitment to the company. Therefore, accepting Higgs’ ban on a chairman chairing the nominations committee is unnecessary and could be worse for the company in the long run.
Expansion of the SID’s Responsibilities
Cadbury, not Higgs, first introduced the SID position and the SID is currently part of the Combined Code. Yet, Higgs subtle re-definition of the SID role may well have a noteworthy impact. Higgs proposes that shareholders unhappy with the chairman may choose to bypass him and communicate only with the SID. Business leaders claim that opening up a separate channel of communication between the board and shareholders, via the SID, could prove divisive and undermine the unified board. Further criticism points out that properly organised shareholder communication is the domain of the company chairman. Encouraging shareholders to go to the SID with concerns may discourage them from following standard protocol, which would detract from the chairman’s core role. According to the CBI poll, eighty-two per cent of FTSE 100 chairmen believe that their ability to run an effective board would be hindered by Higgs’ proposal to upgrade the role of the SID.
Higgs maintains that the SID would simply facilitate a distortion-free channel to process shareholder concerns in cases where the traditional route through the chairman was not working. Despite Higgs’ contentions, it is difficult to see how the expansion of the SID’s role will not impact on the role of the chairman and lead to division within the board. This would not be in the company’s best interest.
Separate NED Meetings
Higgs also proposes that Independent NEDs meet regularly without the executives or the chairman present. The SID would reside over these separate meetings. The CBI poll asked chairmen what they thought about non-executive directors meeting without the management once a year and over half responded that the practice would not be useful for good governance. Only 34% of respondents agreed that these independent meetings would benefit the company. The thinking underlying this recommendation is that non-executive directors will be able to have open, frank communication without the executive directors present. Higgs states that these private meetings will allow easier contemplation of provision of information and succession planning. Anticipating criticism, Higgs points out in his report that these meetings would be informal and would not replace the need for regular meetings of the board as a whole. Therefore, these separate meetings seem to have little potential for negative impact on board politics, especially if they are regularly
7 The nomination committee nominates all directors, both executive and non-executive. However, the board generally does not delegate the nomination of the company chairman to a committee, handling the nomination and vote for this post as a unified board.
14 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 scheduled so as to avoid striking panic with executives when a spontaneous independent NED-only meeting is called.
Remuneration
Some companies wish to pay their directors utilising an options scheme. Higgs’ proposals oppose this route for Independent NEDs, contending that fees paid via options are generally inappropriate because this could generate "an undesirable focus on share price rather than underlying company performance". Alternatively, it is acceptable for independent NED directors to hold shares. Higgs points out that owning shares does not generally threaten independence and will most likely align directors’ interests with those of the shareholders. Of course, if a holding represents a significant portion of a director’s wealth, this will call his independence into question.
Higgs has managed to strike a reasonable balance in this debate over whether independent NEDs should be paid via an options scheme by providing exceptions. His proposals allow companies to distribute options to directors upon shareholder approval. Independent NEDs must also hold those options until one year after leaving the board. These exceptions allow companies to remunerate their directors as they see fit while removing the temptation for non-executives to support hasty stock-inflating actions that may cost the company in the long run.
7.2 The Smith Report: Discussion
The Smith Report, if adopted, will fundamentally alter company audit procedures. The audit committee, comprised of all Independent NEDs, will be charged with the daunting responsibility of ensuring that both internal and external auditor independence is intact. Of Smith’s recommendations to improve auditor independence, the two listed below present noteworthy implications.
Duties Related to External Auditors: Non-Audit Services
As noted in Section 6, Smith sets out principles to guide audit committees when evaluating whether an auditor should provide non-audit services: An audit firm should provide no non-audit services if (1) the external auditor audits its own firm's work; (2) the external auditor makes management decisions for the company, (3) a mutuality of interest is created; or (4) the external advocate assumes the role of company advocate. Smith goes beyond just laying down the principles, to arming the audit committee with questions to ask when considering hiring an external auditor to perform non-audit services.
Smith’s approach keeps in line with the UK fashion of bowing to expertise and experience when appropriate. Smith notes that it is acceptable for auditors to provide non-audit services at times, given that the audit committee believes independence will not be sacrificed. Therefore, audit committees, even after Smith’s recommendations are incorporated, will have the power to make case-by-case decisions regarding the provision of non-audit services. This leeway will benefit UK listed companies. When seeking firms to perform a job that may fall into an undefined area, audit committees can use the best firm for a specific job, even if that firm is its own auditor. When independence is not threatened, firms should not be forced to cut their own auditor from the candidate pool simply to adhere to blanket regulations. Smith has ensured that, with regard to the provision of non-audit services, there is a balance of insulation against compromised auditor independence and deference to corporate judgement.
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Smith has recommended in his report that one member of the audit committee should have "significant, recent and relevant financial experience, for example as an auditor or a finance director of a listed company." The requirement that all members of the audit committee be financially literate is sound. Yet it may be difficult for all listed companies to meet Smith’s further recommendation for the presence of a “financial expert”.
To meet this recommendation, companies must clear two significant hurdles. First, they must recruit a candidate with the requisite skill set. This could be a difficult task as Smith’s examples of this “financial expert” narrow the field; finding a former auditor or finance director of a listed company is a tall order. Next, the company may not look to its own ranks to recruit a “financial expert” as all members of the audit committee must be independent NEDs to be Smith-compliant. These two hurdles will likely pose difficulties for listed companies, especially smaller entities with less resources to devote to the recruitment process and remuneration.
8. COMPARISON HIGHLIGHTS WITH US REFORMS
The UK's corporate governance principle of "comply or explain" differs from the US rules-based scheme, which mandate specific requirements to ensure sound corporate governance. In the US, the SEC has implemented Sarbanes-Oxley by remitting a series of strict rules. US listed companies have no option to explain deviations; all must comply or face regulatory action. Despite their diverse approaches, both the US and the UK have taken some similar measures to shore up their standards of corporate governance. Conversely, US and UK reforms diverge on some topics. Listed below are key reform topics and how both the UK and the US have addressed each:
Integrity of Financial Statements
? UK: (True and Fair View) Section 226 of the Companies Act of 1985 requires directors to prepare for each financial year a balance sheet and a profit/loss account. Both must present a true and fair view of the company's state of affairs.
? US: (Fairly Presents) The SEC has definitely raised the bar for company accounting and disclosure standards by mandating use of the fairly presents guide. The SEC now requires the CEO/CFO to certify quarterly and annually that to their knowledge the financial statements fairly present in all material respects the company's financial condition, results of operations and cash flows. The SEC explained that the fairly presents standards are broader than GAAP and encompass the selection and proper application of accounting policies, the disclosure of financial information that is informative and reasonably reflects the underlying events, and the inclusion of other information necessary to provide investors with a materially complete picture of the issuer's financial condition, results of operations, and cash flows. All employees, including the CEO and CFO, must use the stricter fairly presents standard, as opposed to GAAP, when making accounting or disclosure judgements.
Attorney Conduct: Whistleblowing
? US: The SEC has proposed a rule requiring attorneys to withdraw if issuer clients do not respond adequately when advised of a material breach of securities law.
16 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 The client would then be responsible for reporting its own inadequate response to the SEC. This could have a substantial impact on the sacrosanct attorney-client relationship and will apply to foreign attorneys as well, provided they are appearing before the SEC or acting alone, without US counsel.
? UK: UK reforms do not require attorneys to withdraw in the face of securities law breaches, yet one may draw a comparison between US whistle-blowing requirements and the UK's strict money laundering laws. These UK laws impose the affirmative duty on persons (including attorneys) to promptly report knowledge or suspicions of money laundering to the proper authorities.
Definition of Independent
? UK: Higgs recommends expanding the definition to rule out any directors with relationships that may or could appear to threaten a director's independence.
? US: New US SEC rules clarify rules on directors’ independence, revealing that US laws appear more lenient than UK recommendations. The SEC states that audit committee members may not (1) accept directly or indirectly any consulting, advisory or other compensatory fee from the company or its subsidiaries (other than board and committee fees) or (2) be an “affiliated person”8 of the company or any of its subsidiaries. Unlike in the UK, a director’s independence will not be threatened by his commercial relationships with another company, even if the two entities in question conduct business. Further, US laws do not impose a “look back” period; directors’ independence is evaluated only from the time of their appointment to the audit committee.9
Senior Independent Director Role
? UK: The Smith report recommends appointing someone to liase with the shareholders if questions were not answered through the standard board channels. As noted above in this Report, critics claim this could be a divisive measure.
? US: US reforms do not require the appointment of a SID. Section 301 of the Sarbanes Oxley Act of 2002 mandates only that audit committees as a unit should establish measures to process and address complaints received by the issuer regarding accounting, internal controls, or auditing matters.
Separation of the Roles of CEO and Chairman
? UK: Reforms suggest that these roles be held by two separate individuals and that the CEO should not later be allowed to chair the same company.
? US: US guides realise a distinction of duties yet have no direct equivalent prohibitions on either joint CEO/Chairmen or of CEO's later becoming chairmen of the same company.
8 An “affiliate” of a person will be defined as one who “directly or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with” that first person.
9 Pending NYSE and NASDAQ rules may be more restrictive than the SEC rules regarding audit committee independence.
17 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 Audit Committees Seeking Outside Counsel
? US: US legislative reforms indicate that Audit Committees shall have the authority and discretion to engage independent counsel or other advisors as necessary to perform their duties. The New York Stock Exchange Listing Rules take this a step further and plan to add seeking outside counsel when necessary to the list of directors’ duties.
? UK: Current UK proposals do not require Audit Committees to seek independent counsel, yet Section 3.14 of the Smith Report states that "the board shall make funds available to the audit committee to enable it to take independent, legal, accounting or other advice when the audit committee reasonably believes it is necessary to do so."
Restrictions on Outside Audit Services
? US - US reforms explicitly forbid several services that auditors formerly provided, including bookkeeping, information systems, employee recruitment, appraisals, and more. Note - tax services are still allowed.
? UK - Reforms do not rule out specific services; instead the Smith report advises that audit committees take the utmost care to ensure that external auditors do not in effect audit their own work, become company advocates, participate in management, or share a mutual interest with the company. As noted earlier, audit committees have the authority to assess situations on a case-by-case basis.
Financial Expert on Audit Committee
? UK: One member should have "significant, recent and relevant financial experience, for example as an auditor or a finance director of a listed company".
? US: The SEC will require companies to disclose whether they have a financial expert and, if not, why not. § 407 defines "Financial Expert" much more specifically than the UK Smith Report. Sarbanes Oxley lays out specific knowledge requirements and criteria for determining "financial expert" status.
9. CONCLUSION
This report has outlined the development of corporate governance in the UK and weighed the consequences of current reforms, comparing UK recommendations to their US counterparts. World-wide corporate governance regulations are in flux and proposed changes to the ways in which companies are run and boards operate will fundamentally change international business.
US and UK reforms do not run parallel; this report has highlighted some areas where they converge and diverge. Sarbanes-Oxley in the US has prompted a series of mandatory securities regulations to ensure US public companies toe the line. In the UK, the Higgs and Smith Reports promise to make a significant impact in boardrooms and the business community by altering the Combined Code. Most importantly, the underlying UK corporate governance model, which allows public listed companies the choice of complying with best practices or explaining the deviations, seems to be bending under the weight of current proposals. While safeguards against public company mismanagement, fraud, and collapse are necessary, the UK business and regulatory community must ensure that that the core
18 LONLIB-0108750.01-HALSHAHI 02 May 2003 10:12 corporate governance doctrine of “comply-or-explain” does not slowly transform into a proscriptive US approach of simply “comply”.
Sarah La Voi is studying for a JD and MBA at De Paul University Chicago. Peter Borrowdale is a partner in the transatlantic law firm, Reed Smith. The views expressed in this paper are entirely personal to the authors. Nor does the information in this paper constitute legal advice.
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