The way forward for non-executive directors

by Paul Moxey
10 Jan 2003

Topic: Business, Corporate governance

Are non-executive directors the answer to problems raised by recent accounting scandals? Paul Moxey considers the roles of NEDs

Many see non-executive directors (NEDs) as the solution to most of the corporate problems characterised by Enron, WorldCom, Equitable Life, MyTravel and Vivendi. Yet before these debacles, most people, including a lot of directors, were not sure what non-executive directors were for. Tiny Rowland described them as little more than decorations on a Christmas tree. Since Enron, there now seems to be a growing consensus that NEDs are a mixture of policemen and guardians of shareholders� interests. This view ignores the fact that NEDs also have an important strategic role. It also wrongly assumes that NEDs have a different responsibility, from that of executive directors in respect of a company�s shareholders.

Back in 1998, the UK Hampel Committee commented that NEDs are normally appointed to the board primarily for their contribution to the company�s strategy. Hampel found general acceptance that NEDs should have both a strategic and a monitoring function. Hampel also said that, particularly in smaller companies, NEDs may contribute valuable expertise not otherwise available to management; or they may act as mentors to relatively inexperienced executives. ACCA�s research on the role of NEDs in UK SMEs, and of the views of CFOs of 200 Asian listed companies, supports the view that NEDs play an important role in a company�s success.

There is a danger that the current emphasis on the monitoring role of NEDs will mean that they become less effective in their strategic role. ACCA, in its response to the UK DTI-sponsored Higgs Review of the Role and Effectiveness of NEDs, says there is a pressing need to clarify the role of non-executive directors. Guidance is needed but it should avoid being overly prescriptive. There is a danger that, by creating too �defined� a role, the present unitary board structure and culture could be changed and boards will act less cohesively.

The UK Company Law Review recognised that many directors are still unclear about their general duties and to whom their duties are owed. The new Companies Bill helps clarify this by proposing that a director must act in the way he or she decides would be most likely to promote the success of the company for the benefit of its members as a whole. The Company Law Review is unlikely, however, specifically to address the role of NEDs.

The role of the board, executive directors (EDs) and NEDs and the chairman differ from country to country. In UK company law, there is no definition of NEDs. Legally, all directors are the same. In the UK, and in much of the world, directors� roles instead reflect custom and practice. There are exceptions however. The United States has recently defined the term �independent director� in law. The new Sarbanes-Oxley Act defines an independent director as (broadly) someone who does not receive any fee other than in his or her capacity as a director or member of a board committee. In Germany, and some other parts of Europe, a two-tier board structure is normal. In a two-tier structure, a management board manages the enterprise but is accountable to, and supervised by, a supervisory board elected by shareholders. In German listed companies, the employees will also elect supervisory board members whose job, like other supervisory board members, is to represent the interests of the company as a whole rather than the interests of employees.

There is some debate about which type of board structure is best. ACCA supports the present unitary UK board structure where all directors have equal responsibility in law. ACCA believes boards are most effective when they work as a team. The current focus on the monitoring or regulatory role of NEDs creates the danger that boards will be divided and cease to work effectively together.

ACCA believes that, while reform is needed, any changes should not have the effect of dividing the board by preventing executive and non-executive directors from working as a team. It is also important to ensure that public expectations of NEDs are not raised beyond what can reasonably be asked of them. In common with ACCA�s support for a �principles� approach to financial reporting, ACCA favours clarification of the role of NEDs through changes to the principles in corporate governance codes, such as the UK Combined Code, rather than by new laws.

The below panel indicates just a few of ACCA�s 20 proposals for enhancing the effectiveness of NEDs. Other proposals cover improving disclosure, the appointment, background and education of NEDs, the number of other non-executive directorships a NED might hold, the time NEDs should devote, and other proposals on creating further opportunities for NEDs to be more effective. At the time of writing, the Higgs Review is expected to issue its conclusions this month. It will be interesting to compare Higgs� proposals with ACCA�s. Full details of ACCA�s response to Higgs can be viewed at ACCA�s website. accounting & business will include a follow up article on our other proposals and will analyse the Higgs recommendations once they have been published.

ACCA: the way forward for NEDs

1. ACCA agrees with the Hampel Review that NEDs have both a strategic and a monitoring role. Their effectiveness in their monitoring role needs to be improved, but without impairing their effectiveness in a strategic role. ACCA sees NEDs� monitoring role as including:

bringing external (and independent) influence to bear on issues such as financial performance, risk, internal control, standards of conduct, compliance, probity and the evaluation of management and board performance
deciding the remuneration of the executive directors (EDs)
effecting changes in board composition when governance or performance issues suggest that this is necessary, but it is unlikely to be initiated by the EDs, and
making recommendations to shareholders on the appointment of auditors.

The last three functions should be carried out without the involvement of EDs.

2. NEDs should act as the �corporate conscience� in respect of CSR issues. As the issue of corporate social responsibility (CSR) rises up the business agenda, it is appropriate for NEDs to accept a responsibility for ensuring that social, environmental and sustainability issues receive an appropriate degree of board level attention. This will become particularly significant if the proposed mandatory Operating and Financial Review Statement becomes law in the near future.
NEDs should also be sensitive to the public interest issues inherent in balancing long-term sustainable growth with the short-term financial demands associated with the recruitment, retention, motivation and reward of the EDs.

3. NEDs should exercise individual judgement, but they should act primarily through the board or in committees rather than individually. NEDs would become more like EDs if they regularly made decisions on their own which committed the company, or would be likely to do so.

4. NEDs should prepare their own governance report to shareholders, as part of the annual report. This report should explain how NEDs consider that they have fulfilled their monitoring role, and should cover the work of the non-executive committees such as the audit and remuneration committees.

5. Through the audit committee, NEDs should give prior approval to any non-audit work to be carried out by the external auditors, and they should regularly assess the independence of the auditors. The audit committee should disclose its assessment of the independence of the auditors, and the reasons for awarding any non-audit work to the auditors, as part of the NEDs� governance report. Trends in the balance of audit and non-audit fees should be monitored and significant changes fully explained.

Paul Moxey is head of risk management and corporate governance at ACCA.

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The way forward for non-executive directors