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The Non-executive Director: From Wallflower to Pivotal Player

Tuesday, February 7, 2012
Sarah Jane Leake | Bloomberg Law Historically, company boards were insider-dominated, comprised mainly of full-time executives. Non-executives (NEDs) served mainly as a sounding board, to provide a "window on the world," and to allow companies to draw on their experience. As such, many companies were run akin to fiefdoms with NEDs, if any, playing a purely decorative role. NEDs were commonly considered wallflowers, who should refrain from asking discerning questions that may embarrass the CEO. The board meeting was generally not regarded as a debating society, and NEDs were expected to ask questions of a gentler, more sympathetic nature. Abrasive and challenging questions were not considered appropriate and could be perceived as a vote of no confidence in the CEO.1 Yet, NEDs are well positioned to play a pivotal role in the active governance of firms. Corporate governance relies on effective systems and procedures to ensure proper checks and balances are in place to monitor directors' activities and NEDs are generally considered as providing an independent check in this monitoring function. The role of the NED has been subject to significant scrutiny and increased regulatory focus over the years. Now, in the wake of the financial crisis, NEDs are expected to take a much more active role, particularly in the policing of financial institutions, to help avoid against another set of financial disasters.

Change

Several corporate scandals in the 1980s and early 1990s served to highlight that many NEDs were failing to exert effective control over dominant chairmen. Against this backdrop, the Cadbury Report, produced by a committee chaired by Sir Adrian Cadbury, was published. Amongst other things, this report sought to enhance the responsibilities and public visibility of the NED. It suggested that the majority of the board of directors should be comprised of NEDs, and that at least three NEDs should sit on the remuneration committee and audit committee. Sir Adrian stressed that the main role of the NED is to provide a creative contribution to the board, by giving objective criticism and advice. This is in stark contrast to previous widely accepted practices. Sir Adrian's focus on the supervisory role of the NED was, however, criticised by many, primarily on the basis that it would lead to divisions on the board between the executive and the non-executive members. This does not, however, appear to have happened in practice. Post-Cadbury, the NED is expected to act as a constructive critic. As an outsider, he may have a more objective view of external factors affecting the company in its business environment than the executives. He should therefore take responsibility for monitoring the performance of the executive, especially with regard to company strategy. Unlike before, NEDs are now expected to ask discerning questions, and to continually probe where they have any doubts or concerns.2

Law & Regulation

While the Companies Act 2006 (CA 2006) does not distinguish between an executive director and a NED, the non-executives, in the unitary board structure that prevails in the UK, essentially have the same legal duties, responsibilities, and potential liabilities as their executive counterparts. Although it is acknowledged that NEDs cannot and do not give the same continuous attention to the business of the company, it is nonetheless important that they show the same commitment to its success as the executive directors. — The UK Corporate Governance Code Listed companies are subject to the requirements set out in the Financial Reporting Council's Corporate Governance Code (Governance Code). The Financial Services Authority (FSA) has incorporated the principles set out in the Governance Code into the Listing Rules (LR), which form part of its handbook. A listed company must therefore apply the Governance Code's principles and explain to its shareholders in its annual report how it has done so.3 Appointment to the Board In line with the Governance Code, a board should include a balance of executive directors and NEDs (in particular independent NEDs4), such that no individual or group of individuals can dominate.5 NEDs should be appointed for specified terms, subject to re-election, and to the statutory provisions regarding the removal of a director.6 Any term in excess of six years should be subject to rigorous review and take into consideration the need for progressive refreshing of the board.7 Furthermore, the board should appoint one of the NEDs to be the company's senior independent director, whose main role is to provide a sounding board for the chairman and act as an intermediary, where necessary, for the other directors.8 Leadership NEDs in listed companies are required to constructively challenge and help develop the company's proposals on strategy.9 In particular, they should scrutinise the performance of management in meeting objectives and monitor the reporting of performance.10 Any concerns about the running of the company or a proposed course of action that cannot be resolved should be recorded in the company's board minutes.11 Moreover, NEDs are expected to play a prime role in appointing and, where necessary, removing executive directors from office.12

Controlled Function

NEDs at an FSA-regulated firm also need to be approved by the FSA as the role is classified as a controlled function (CF) and, more specifically, a significant influence function (SIF).13 In order to perform this role at a regulated firm, prospective NEDs must adhere to the standards set out in the FSA's Fit and Proper Test for Approved Persons (FIT) and, once approved, adhere to the FSA's seven Statement of Principles.14 When assessing whether a NED is sufficiently fit and proper, the FSA will take into account his: (1) honesty, integrity, and reputation; (2) financial soundness; and (3) competence and capability.15 Historically, the FSA focused on the first two categories, trusting firms to ensure that the relevant individuals met the requisite standards of competence and capability. This, however, changed in 2009 and the FSA is now much stricter in its approach, thoroughly assessing the competence and capability of applicants by way of a three-stage process, including an interview. NEDs sitting on boards of FSA-regulated entities are therefore expected to play a more pivotal role in the firm's governance. Only a few months ago, it stressed that NEDs "have a duty to challenge the management of their firms where they believe the firm could do more to ensure that customers get fair treatment."16

Skill & Care

The standard of skill and care expected of NEDs is the same as that applied to executive directors in discharging their duties. In Dorchester Finance Co. v Stebbing (1989), Foster J stated that a NED: (1) is under a duty of skill and care expected from a person of his knowledge and experience; (2) must take such care as he might be expected to take on his own behalf; and (3) should exercise the power vested in him in good faith and in the interests of the company. Moreover, pursuant to section 174(1) CA 2006, a director (and therefore also a NED) must exercise reasonable care, skill and diligence. The degree of reasonableness in question is dictated by a balancing act between: (1) the care, skill, and diligence that would be exercised by a reasonably diligent person; (2) the general knowledge, skill, and experience that may reasonably be expected of a person carrying out the functions undertaken by the director in relation to the company; and (3) the general knowledge, skill, and experience of that individual director.

The Years Ahead: Regulatory Change

In hindsight, it is clear to the FSA that, in the run up to the crisis, boards did not sufficiently understand the risks they were running and received little NED challenge. NEDs should, stresses the FSA, already be using their experience and expertise to identify, highlight, and challenge any development that could pose a risk to strategy, profitability, or reputation. This role should be extended, opines the FSA, to identifying, highlighting and challenging any developments that could pose risks to the firm's customers.17 While NEDs are said to have adapted reasonably well to this new era of heightened accountability, the FSA considers that boards are still not fulfilling their potential. The FSA is currently consulting on further guidance to help these directors understand the FSA's expectations of them in this post-crisis landscape.18 It is clear that more constructive challenge is needed, in order to provide a robust and insightful challenge to executive management on all aspects of the business, including culture. The FSA expects, at a minimum, NEDs to consider the following areas and seek to ensure that:
  • Business proposals are aligned with the firm's conduct risk strategy and are within its stated conduct risk appetite. NEDs should, for example, encourage the board to discuss customer expectations and how the firm can deliver against them.
  • The firm's culture is such that it delivers good behaviours and outcomes, both prudentially and for customers. To this end, a NED should encourage the board to establish and maintain a culture that supports an appropriate degree of customer protection.
  • They have the right information to enable them to make robust business decisions. In particular, NEDs should ensure that the information provided is sufficient to support decision-making.
  • Risks to customers have been identified. NEDs should, for example, be comfortable with the level of priority assigned to retail conduct risk.
  • Appropriate actions are in place to mitigate and monitor such risks.
  • The board supports the identification and escalation of issues when they go wrong and ensures appropriate resolution. To this end, a NED should encourage the board to cultivate an open and collaborative working environment.
  • The business learns from identified lessons and draws out the wider implications. The board should, for example, be challenged to identify the root causes of issues to help prevent them from reoccurring.
  • In his Mansion House speech in 2010, Hector Sants, FSA chief executive, stressed that "a box-ticking approach to regulating culture will not work. The regulator must focus on the actions a firm takes and whether the board has a compelling story to tell about how it ensures it has the right culture that rings true and is consistent with what the firm does."19 In future years, the FSA, and, shortly, the new conduct of business regulator, the Financial Conduct Authority, will be paying much closer attention to the culture of firms. This, specifically, will focus on how NEDs challenge management and seek to embed a good culture throughout the firm. The role that NEDs are expected to play will therefore intensify and expand, as they are now required to play more of a frontline role. -------------------------------------------------------------------------------- 1 See Myles L. Mace, Directors: Myth and Reality (Harvard Business School Classics, 1986). 2 Non Executive Directors Conference; Delivering Fair Treatment for Consumers of Financial Services – FSA Guidance Consultation, Dec. 2011. 3 LR 9.8.6(5). 4 The test for independence is set out in Provision B.1.1 Governance Code. 5 Supporting Principle B.1 Governance Code. 6 Sections 168 and 169 CA 2006. 7 Code Provision B.2.3 Governance Code. 8 Code Provision A.4 Governance Code. 9 Principle A.4 Governance Code. 10 Supporting Principle A.4 Governance Code. 11 Code Provision A.4.3 Governance Code. 12 Supporting Principle A.4 Governance Code. 13 These are set out in the FSA's Supervision manual (SUP) at SUP 10.4. 14 These are set out in the FSA's Statements of Principle and Code of Practice for Approved Persons sourcebook (APER) at APER 2.1. 15 FIT 1.3.1. 16 FSA sets out its expectations of non-executive directors in managing risks to retail customers – FSA Press Release FSA/PN/106/2011 of 7 Dec. 2011. 17 Id. 18 Supra note 2. 19 Can culture be regulated? – Speech by Hector Sants, Chief Executive, FSA, Mansion House Conference on Values and Trust, 4 Oct. 2010. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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