In the wake of corporate scandals, primarily in the US (WorldCom, Tyco or Enron), the UK Government commissioned Sir Derek Higgs in April 2002 to produce a report on the role and effectiveness of Non-Executive Directors. While recent corporate failures triggered those reflections, the concern for corporate transparency and accountability has more fundamental roots in the shareholder revolution of the last decades. As a leader in the Economist (April 19, 2003) states,
"... institutional investors own a bigger share of American equities than ever before: 49%, four times as much as 40 years ago. As the institutions' share of equities rises, so the option to sell declines and the case for raising a stink gets stronger. If institutions behave like owners, companies will be well governed. Regulators must remove all obstacles that discourage them from doing so. Then it will be clear whether bad governance springs from market failure - or investor apathy."
The Higgs Report made wide-ranging recommendations to clarify roles in the boardroom and make procedures more transparent. Importantly, large parts of the Report were incorporated into the Combined Code on Corporate Governance. Although the Combined Code is based on a governance principle of 'comply or explain', this and the fact that it forms part of the UK listing rules, should give campaigners an important entry point to hold corporations to transparent and accountable structures and practices.
This briefing sets out the context, the recommendations made by Higgs, as well as the debate following it up to the integration into the Combined Code.
REVIEW OF CORPORATE GOVERNANCE IN CONTEXT
The commissioning of the Higgs report has to be seen in the context of a wider review of the substance and procedures of corporate governance. It was published in January 2003, together with the Financial Reporting Council's report on 'Developing the Guidance on Audit Committees' (Smith Report).
The Higgs Report builds on the Combined Code, which constituted the framework of corporate governance and which itself results from three different reports:
- Cadbury Report, 1992, on the Financial Aspects of Corporate Governance
- Greenbury Report, 1995, on Directos' Remuneration
- Hampel Report, 1998, on Corporate Governance
SUBSTANTIAL SUGGESTIONS OF THE HIGGS REPORT
The main issues of the review, also put forward for incorporation into the Combined Code, are summarised below:
THE BOARD AND INDEPENDENCE - Higgs increases the norm of the Combined Code, that not less than a third of the Board should be non-executive directors, to half of the Board, excluding the Chairman, being made up of independent non-executive directors. The operation of the Board as well as the number of meetings, attendance by individual directors, etc should be published in the annual report. Furthermore, a director is defined as not independent where s/he
- has been an employee of the company within the last fiveyears
- has had a material business relationship with the company in the last three yeas
- has received remuneration beyond the directo's fee (share options are not recommended as form of remuneration)
- has close family ties, cross-directorships or represents a significantshareholder
- has served on the board for more than ten years.
THE ROLE OF THE NON-EXECUTIVE DIRECTOR - Although Higgs does not call for a legal distinction between executive and non-executive directors, a clarification along four dimensions was seen to be useful and later on encompassed into the Combined Code. Non-executive directors
- should constructively challenge and contribute to the development of strategy,
- they should scrutinise the performance of management and monitor the reporting of performance,
- should check the accuracy of financial information as well as the robustness of financial controls and systems of risk management, and
- are responsible for executive directos' appropriate levels of remuneration and have a prime role in appointing and removing senior management as well as in succession planning.
Further recommendations include for the non-executive directors to hold meetings on their own as a group and to conduct due diligence prior to their appointment.
THE SENIOR INDEPENDENT DIRECTOR - Building on an existing Code provision, each company should identify a senior independent director who is available to shareholders in case they have concerns that could not be resolved with the Chairman or the Chief Executive.
RECRUITMENT AND APPOINTMENT - Provisions in this area go beyond the Combined Code by insisting on a nomination committee (1), the majority of which is made up of 'independent' non-executive directors (2) and which is chaired by an independent non-executive director (3).
The review criticised the 'high level of informality' common in non-executive appointments and underlined the importance of formal recruitment processes. The nomination committee should consider criteria such as the required role, skills, knowledge, and experience of the candidates before making recommendations to the Board, which, in turn, should give reasons for its appointments to the shareholders. Non-executive directors should always be appointed on written appointment terms requiring the candidates to confirm that they are able to enter such time commitments.
Limits were also placed on multiple appointments: Higgs suggested that a full-time ED should not have more than one NEDship, not be Chairman of another company, and nobody should be Chairman of two major (FTSE 100) companies. However, the report does not limit the number of NEDships one can hold.
REMUNERATION - Generally, fixed fees are endorsed while payment in shares is deemed appropriate as long as the resulting shareholding does not represent a large proportion of a NEDs wealth. Share options are disapproved of as they would distort the focus on the underlying company performance.
INDUCTION AND PROFESSIONAL DEVELOPMENT - Emphasising the formalisation of non-executive directorships the Review foresees an induction programme as well as regular refreshment of skills and knowledge up-dates. Annual performance evaluations of the Board, its committees and each individual member should be reported in the annual company report.
THE CHAIRMAN - Higgs insisted on the separation of the roles of the Chairman and the chief executive. ‘In any event the code provides that if a CEO must move to the role of chairman on an ‘exceptional’ basis, the shareholders should be consulted in advance and the reasons included in the annual report, offering a pragmatic solution for companies and shareholders.’ (McNeil/Rimmington 2004, 50)
The publication of the Report as well as the suggested Code of Practice that was to be incorporated into the Combined Code certainly sparked a broad debate. While institutional investors (e.g. the National Association of Pension Funds) mostly supported the changes, the ‘Economist’ wrote at the time, under the heading ‘Hating Higgs’, that ‘Britain’s corporate chairmen are up in arms’ over the review and quoted the findings of a CBI (Confederation of British Industry) poll of the top 100 companies (responses from 61 chairmen). According to this survey, the two provisions that drew most of the criticism concern
'... the designation of a senior non-executive director (82% against, 57% strongly so) and the chairing of the committee nominating new directors (87% against, 61% strongly).'
Various issues seem to be at stake here. First, above criticism is directed against changes in the roles and power structure within the boardroom, particularly with regard to the role of the Chairman (women still have made few inroads to the position of Chair). Higgs’ suggestions see the Chairman’s role as providing a balance vis-à-vis the CEO and the Board of Directors; it strengthens the role of non-executive directors to create yet another ‘independent’ channel for shareholders’ concerns.
Thus the criticism against the senior non-executive director’s responsibility to communicate with shareholders (a role so far filled by the Chairman, even in the provisions of the Combined Code) and against establishing a non-executive director as Chair of the Nomination Committee for Non-Executive Directors. However, Higgs himself replied that identifying a senior independent director was already an existing provision of the Combined Code and, more generally, the Financial Reporting Council said that changes would only be made if the recommendations were found to contain a 'fatal flaw'.
A more general criticism was directed at the number of suggestions for the revised Combined Code. The Code contains ‘principles’ on the one hand, ‘code provisions’ on the other. As Higgs recommended the incorporation of just one principle but 37 code points, this was seen in resulting in an overly prescriptive Code.
As corporate governance was based on the principle of 'comply or explain', a lot of work is required for either. A director of a proxy-voting company, for example, estimated that ‘every company in the FTSE 100 breaks at least one of the provisions (Economist, March 15, 2003). Equally, it has often been warned that smaller companies in particular will find it difficult to recruit experienced and high-quality non-executive directors (according to one estimate, companies overall would have to find 1,000 new NEDs to comply with the regulations).
AFTERWORD: INCORPORATION INTO THE COMBINED CODE
A major part of corporate governance in the UK is based on a code of conduct, the Combined Code drawn up by the Financial
Reporting Council. This form of governance does not rely on enforcement via regulation but rather tries to secure accountability via a practice of ‘comply or explain’. After a very brief consultation process the Financial Reporting Council set up a working group, which included major stakeholders, to consider the submissions. By the end of May 2003, regarding Higgs’ recommendations for the revised Combined Code, some changes were made:
'The chairman should be allowed to chair the nomination committee; that no limit should be put on re-election of non-executive directors; that companies outside the FTSE350 should not have to have at least half independent directors; and that some of the provisions in the draft were more akin to principles.' (Jones and Pollitt 2004, 166)
The Financial Reporting Council published this revised Combined Code in July 2003, to be implemented in company reports from 1 November 2003. Section 1 of the revised Code equally forms part of the UK listing rules.
It is important to note, that the option the UK has taken with the enlarged Combined Code stays within a voluntary framework and is therefore opposed to developments in the US which has chosen legal intervention through the Sarbanes-Oxley Act.
Interestingly, immediately following the publication of the report a number of high-profile companies such as Rexam, Sainsbury and Barclays made appointments against the recommendations set out in the new Combined Code. However, drawing on the results of two Deloitte surveys (pre- and post-Higgs), McNeil and Rimmington (2004, 49) however, report on changes in boardroom practices:
'The scrutiny over the last year of independence issues appears to have resulted in a corresponding change to the composition of the board in 80 percent of participant companies. There has been a shift towards the recruitment of non-executives, with more executive directors leaving than being recruited, and conversely more non-executive directors are being recruited than are leaving. This is consistent with our wider research into FTSE 350 companies which has shown an overall increase in non-executive role numbers, along a decrease in executive numbers.'