2.5.8 Getting the best out of NEDs

After the separation of the functions of the CEO and the chairman, the second next most far-reaching development in the UK during the last 15 years has been the enhancement of the role of the Non-Executive Directors (NEDs), as a result of the various codes and the pressure of institutional investors.

The role of NEDs has been enhanced in many ways:

The following sub-paragraph discusses what can be done to make NEDs function optimally.

"How complex and demanding the role is today is aptly portrayed by this job advertisement

It is clear that NEDs have to have an understanding of the company's operating environment, e.g. technological change, legal and regulatory developments; the dynamics of the industry; competitors; and customers.

Challenging the executives means getting them to distinguish between prejudice and fact. There is the temptation, especially where executives have worked together over an extended time, for management to lapse into not readily noticeable underperformance. Challenge by NEDs can prevent such slack. For BOFIs, Walker recommends a majority of NEDs with financial experience.2

NEDs need to have strong interpersonal qualities (people's skills). The Higgs Review sums it up as follows: "The key to NED effectiveness lies as much in behaviour and relationships as in structure and process."3 The Higgs Review adds that consultation responses have identified personal attributes as integrity and high ethical standards, sound judgment, the ability to challenge and probe and strong interpersonal skills 4 Summarizing, the personal skins of effective NEDs, they should question intelligently, debate constructively, challenge rigorously, and decide dispassionately. NEDs need to make effective contributions which enable them to gain the trust of the executives.5 Sir Adrian Cadbury quoted Geoffrey Mills and Angus Murray as follows: "A good non-executive director needs to have intellect, integrity and courage. Of these qualities, courage is the most important, for without it, the other two characteristics are useless."6

NEDs must have many qualities and they face at least three dilemmas:7

NEDs must be independent, which is described in sub-section 2.4.7 above.8

After the Higgs Review the time involvement for NEDs increased by about 20% between 2003 and 2006. The time commitment for a typical NED can be estimated as two days a month, broken down into one meeting a month plus one day's preparation. Chairmanship or membership of board committees or attending strategy development sessions would be additional.

Research has shown that an executive director in one company becomes ineffective as a NED in another company, in case he has more than two NED appointments in other companies. The general rule of thumb is that if you are a person who makes it a full-time job to be NED, then five appointments are "doable". However, this is based on the assumption that the companies are all performing satisfactorily. If one or more of the companies gets into difficulties, management of the NED's personal diary becomes an issue. Numerous directors in this situation suddenly find the need to cancel their holidays. There are significant pitfalls if you do not devote sufficient time to the role of a NED. As soon as there are difficulties, even five directorships are too much.

This diagram makes clear the time spent.9

Since 2006 time spent on all aspects has been increasing. Walker recommends 30 to 36 days for NEDs of BOFIs.10

Is it worth being a NED? In the UK the simple answer is that in purely financial terras it is almost certainly not worth it.

A NED would receive between £ 10,000 and £ 40,000 p.a. in a small quoted company and £ 50,000 to £ 100,000 in a large quoted company. These amounts are higher than those received by Dutch supervisory directors and lower than those of their US counterparts. For chairmen the figures are about five times as high.11 In the UK the NED, unlike US independent directors, do not receive options on shares in the company or performance-related elements.12 They may buy shares.

An important element of an outside director's work involves contact with lower management. This starts during the period of due diligence before accepting the appointment and, after acceptance, then continues during induction and subsequently while on the job. An outside director should be curious and wish to meet with lower management and see factories. The opportunities are easily available in a one-tier system, less so from the position of a supervisory board member in a two-tier system, where such contacts should be arranged through the chairrnan.13 The chairman, with the help of the company secretary, has the responsibility for arranging for proper due diligence, induction, professional advice and information.14 These aspects, especially induction and visits to factories, are often mentioned in the annual reports of the company.

The role of the SID was first proposed in the Hampel Report in 1998 and its value was reiterated in the Higgs Review of 2003 to the extent that it is now enshrined in the Combined Code.15 Prior to the Hampel Report, there had been a number of situations where a dispute in the board led to one of the NEDs taking the initiative in resolving the conflict.

In simple terms, the role of the SID is to act as an alternative to the chairman, particularly where there is a possibility of the chairman's thinking being unduly influenced by the executive directors, thus potentially compromising the effective working of the board. The SID should be available to shareholders, when these are concerned that they cannot resolve issues with the chairman or chief executive through normal channels of contact. Additionally, the SID should chair meetings of non-executive directors when the chairman does not attend. Shareholders may also wish to voice their unhappiness about the chairman. In such cases the SID should listen and possibly act and when necessary chair the Nominations Committee.16 It is ideal to have a SID who does not have the ambition to be chairman.

Membership of the principal board committees — nomination, remuneration and audit — involves a significant time commitment for NEDs. Nearly all quoted companies have these committees. Similarly, private companies, especially those which are backed by private equity or venture capital, are introducing audit and remuneration committees.17

Scrutiny by both remuneration and audit committees has increased in recent years: by remuneration committees because of the media's fixation with the "fat cat" syndrome and by audit committees because of their responsibility for the accuracy of the company's annual report and accounts.

The Smith Report on Audit Committees, which was released at the same time as the Higgs Review, states that the audit committee should consist of at least three independent NEDs, one of whom should have significant, recent and relevant financial experience. The Smith Report has greatly increased responsibility for checking published accounts. These requirements, together with the greater scrutiny introduced by Sarbanes-Oxley in the US, have affected the willingness of UK NEDs to serve on audit committees. In the Ernst & Young Corporate Governance Survey published in January 2005, two-thirds of NEDs stated that they were less likely to accept the position of chairman of the audit committee than twelve months earlier.

Another relatively recent issue facing NEDs is that of board evaluation. The Higgs Review recommended that board evaluation should be introduced and it was included in the Combined Code. The principles are listed below:

Board evaluation is starting to make an impact. An experienced chairman commented that he was now seeing very few "duds" in boardrooms, and he considered that NEDs were much more professional than they were five years earlier.23

NED training is an interesting but sensitive issue. The Higgs Review made two statements on NED training. First, "[t]here should be a step change in training and development provision for board members." As a result of this observation, there was an initial rush of supply of new training providers. In 2006 very few remained. Despite the encouragement of Higgs, there has not been a step for change in demand by NEDs for training. Research led to the conclusion that "62 percent of NEDs in listed companies have never received any training for their role."24

Over the past few years the issue of diversity on boards has been debated extensively. The Higgs Review highlighted the Jack of diversity and its research concluded that previous board experience is often seen to be the main, and sometimes only, competence demanded of potential NED candidates. Walker raised the point of diversity again.25

The appointment system is to be formalised. The importance of orderly succession is described below in 2.5.9.

All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance. The board should ensure planned and progressive refreshing of the board.26 This provision emphasizes the power of shareholders and the importance of succession.

Under the CC of 2008 NEDs are to be re-elected after the first 12 months and then again after 3 years. The CG 2010 for FTSE 300, however, demands re-election each year. This is important to avoid acceptance of underperformance and lingering bad relations, is the argument. Now the Walker Review has recommended re-election of the chairman every 12 months.27 The counter-argument is that this creates short-termism as has been mentioned by the UK's biggest investment funds.

Generally, the thinking is that NEDs, if re-elected several times, should not serve more than nine years. In any case they will cease to be regarded as independent after nine years.28 Any term beyond six years for a NED should be subject to rigorous review and should take into account the need for progressive refreshing of the board.29

All directors are elected by shareholders, who have the power to remove them in an AGM,30 but in practice a formal dismissal is rare. Because the shareholders do have the built in right to dismiss, shareholders can exert real pressure to get rid of a director. In the US there is no prospect of companies being made effectively accountable to their owners, because shareholders lack the ultimate weapon of being able to dismiss boards. As a result, when crisis strikes, there is no option in the US but to resort to huge pressure by shareholder activists as in the case of General Motors (GM) in 1993 and now happens quite often. Shareholders of Apple, for example, have put tough demands on succession.31

In the UK NEDs receive and sign 3- or 4-page appointment letters. This shows that serious thought is given to the appointment of NEDs in Britain.32 This example should be followed in other countries.