The Importance of Board Independence (IVOR nr. 90) 2012/6.5.2:6.5.2 Recommendation (2005/162/EC)

The Importance of Board Independence (IVOR nr. 90) 2012/6.5.2

6.5.2 Recommendation (2005/162/EC)

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Based on the advice of the High Level Group, the Commission states in A Plan to Move Forward that one European corporate governance code is not desirable (Commission of the European Communities 2003: 11-12). Such a code would not contribute to providing full information to investors, because corporate governance rules still rely heavily on widely divergent national company laws. Furthermore, it is expected not to lead to an improvement of corporate governance in the European Union, because existing diversity between countries causes the

Commission to confine itself to abstract principles only. Therefore, the Commission has established Commission Recommendation (2005/162/EC) ‘on the role of non-executive or supervisory directors of listed companies and on the committees of the (supervisory) board’ (hereafter: the Recommendation), which can be implemented by the member states and customised to the national context.

In line with the advice of the High Level Group, section 4 of the Recommendation does not give a specific requirement with respect to the composition of the board. But the Commission states that a sufficient number of independent NEDs in a unitary board and independent SDs in a dual board structure should be present in order to ‘ensure that any material conflict of interest involving directors will be properly dealt with’. In section 3.1 it is added that the ratio between executive directors and NEDs in a unitary board and members of the management board and supervisory board should be in balance. This balance should be such that no individual or small group can dominate decisions.

Section 6 of the Recommendation gives the aim of board committees. They should increase the efficiency of the whole board or supervisory board ‘by making sure that decisions are based on due consideration, and to help organise [the board’s or supervisory board’s] work with a view to ensuring that the decisions are free of material conflicts of interest’. Precise formulations of the tasks of board committees are given in Annex I of the Recommendation. The requirement of a sufficient number of independent NEDs in a unitary board and independent SDs in a dual board is also applicable to the composition of these board committees. These independent supervisors should be involved in the areas of nomination, remuneration and audit (section 5). The board committees with these tasks should be staffed with at least three members, whereas two members are sufficient for smaller companies (section 1.1 of Annex I). The requirement of a sufficient number of supervisors on a board committee is probably intended as a recommendation to have board committees which have a majority of independent supervisors. Although this is not explicitly mentioned in the Recommendation, this seems to be the case. Especially when section 3.1 about the appropriate balance for the whole board or supervisory board is considered, this must be concluded. A minority of independent members is not sufficient to prevent other members from being dominant on the board committee. Furthermore a minority is not effective in playing a key role on the board committees as is required in section 5 of the Recommendation.

A company can also decide to establish less than three board committees and to combine certain functions within one board committee. For small boards or supervisory boards, the whole board or supervisory board may fulfil the duties assigned to the board committees as long as the requirement with respect to composition is complied with (section 7).

According to section 13.1 of the Recommendation, a supervisor is independent only ‘if he is free of any business, family or other relationship, with the company, its controlling shareholder or the management of either, that creates a conflict of interest such as to impair his judgement.’ In order to determine the independence of a supervisor, the Recommendation has identified ‘a number of situations reflecting the relationship or circumstances usually recognised as likely to generate material conflicts of interest.’ (Section 13.2) However, this list leads to independence in form. If the board or supervisory board is of the opinion that the supervisor in question is not independent in fact or in appearance, despite his independence in form, the board or supervisory board can decide otherwise and label him non-independent. The opposite may also be true. This entails that if one of the independence criteria applies to a supervisor, but that the board or supervisory board is convinced of his independence (in fact or in appearance), they can label him independent. Annex II of the Recommendation offers a list of independence criteria:

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‘not to be an executive or managing director of the company or an associated company, and not having been in such a position for the previous five years;

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not to be an employee of the company or an associated company, and not having been in such a position for the previous three years, except when the non-executive or supervisory director does not belong to senior management and has been elected to the (supervisory) board in the context of a system of workers’ representation recognised by law and providing for adequate protection against abusive dismissal and other forms of unfair treatment;

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not to receive, or have received, significant additional remuneration from the company or an associated company apart from a fee received as nonexecutive or supervisory director. Such additional remuneration covers in particular any participation in a share option or any other performance-related pay scheme; it does not cover the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the company (provided that such compensation is not contingent in any way on continued service);

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not to be or to represent in any way the controlling shareholder(s) (control being determined by reference to the cases mentioned in Article 1(1) of Council Directive 83/349/EEC (1));

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not to have, or have had within the last year, a significant business relationship with the company or an associated company, either directly or as a partner, shareholder, director or senior employee of a body having such a relationship. Business relationships include the situation of a significant supplier of goods or services (including financial, legal, advisory or consulting services), of a significant customer, and of organisations that receive significant contributions from the company or its group;

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not to be, or have been within the last three years, partner or employee of the present or former external auditor of the company or an associated company;

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not to be executive or managing director in another company in which an executive or managing director of the company is non-executive or supervisory director, and not to have other significant links with executive directors of the company through involvement in other companies or bodies;

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not to have served on the (supervisory) board as a non-executive or supervisory director for more than three terms (or, alternatively, more than 12 years where national law provides for normal terms of a very small length);

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not to be a close family member of an executive or managing director, or of persons in the situations referred to in points [above]’.

This list is more extensive than the list provided by the High Level Group: the business relationship, the links with the external auditor and the maximum tenure have been added by the Commission. These examples should be adopted by the member states of the European Union, but these criteria may be adapted to the situation in the individual member states (Annex II).

Section 13 of the Recommendation requires the disclosure of whether a new supervisor is independent or not, based on the criteria. If a supervisor is considered to be non-independent, the reason for non-independence should be disclosed. As independence can change over time, the independence should be re-assessed periodically. Furthermore, Annex II requires an independent supervisor ‘[…] (a) to maintain in all circumstances his independence of analysis, decision and action, (b) not to seek or accept any unreasonable advantages that could be considered as compromising his independence […].’ Therefore, he must retain his independence in fact and in appearance and must be aware of the risks when he is no longer independent.

The role of the chairman of the board or supervisory board is also discussed with respect to independence. Section 3.2 of the Recommendation states that previous responsibilities of the chairman should not hamper his ability to exercise objective supervision. It is suggested that the CEO and chairman positions be separated in a unitary board structure, but this is not required. Another solution is to use a cooling down period, which means that a former executive director or member of the management board does not become chairman immediately after his resignation. If a solution does not implement any of these recommendations – i.e. having CEO duality or a chairman who is appointed immediately after his resignation as executive director or member of the management board – the company should provide information about safeguards that are put in place in order to ensure that the chairman will perform properly.

In section 1.1 the Commission recommends that the requirements from the Recommendation be implemented either via the comply or explain approach or via legislation, ‘and with the best instruments best suited to their legal environment.’ In February 2007, sixteen out of twenty-one EU countries1 had already included a list of independence criteria (Commission of the European Communities 2007: 13). The next chapters of this study describe the legal framework with respect to independence for European countries, for which this Recommendation is intended. These chapters show that the countries have indeed decided to implement the Recommendation based on their own preferences. The differences are emphasised in chapter 10 which provides a comparison. The next subsection discusses the Green Paper of the European Commission on corporate governance.

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