In July 2003, following the Smith and Higgs Reports a revised Combined Code on Corporate Governance was issued by the Financial Reporting Council Ltd (2003) becoming applicable to all listed companies for reporting years after 1 November 2003. Since then, significant number of changes has been made to the code especially in 2006 (FRC, 2006). Elliot B. and Elliot J. 2006, p 761 are of the opinion that “The combined Code is described in the Preamble to the Code as ‘a consolidation of the work of the three committees, not a new departure”.
Government concern and the various reports and Codes noted above have been influenced by the views of key institutional investors, in particular the Institutional Shareholders’ Committee (1991, 1993) and the Association of British Insurers (1990, 199); and by various “academic studies” (for example, Short, 1996; Clifford and Evans, 1997; Turnbull, 1997; Gay, 2001; Dedman, 2000).
Key provisions of the revised Combined Code
A crucial change in the new Combined Code compared to previous ones is the emphasis it now places on the importance of the contribution made by non-executive directors in a company's governance structures and decision-making processes.
The new Code first, shifts the “balance of power” in the Board and its Committee structures away from the company's executive directors placing increased responsibilities on the non-executive directors. Second, places more emphasis on non-executive directors being “independent” so as to bring greater impartiality and objectivity to the company's decision-making processes (FRC, 2006).
These are the six key provisions of the revised Combined Code on a company's governance structures:
- there should be a clear division of the roles of the chairman and chief executive and these positions “should not be exercised by the same individual”.
- the chairman “should be an independent non-executive director when first appointed”.
- “at least half the Board, excluding the chairman, should consist of independent non-executive directors”.
- “the Nominations Committee should consist of a majority of independent non-executive directors”.
- “the Remuneration Committee should comprise at least three members all of whom should be independent non-executive directors”.
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“the Audit Committee should comprise at least three members all of whom should be independent non-executive directors” (FRC, 2006)
The question which remains is whether all UK large companies comply with the comply or explain philosophy.
A survey was conducted by Christopher Pass, 2004 on “ Corporate governance and the role of non-executive directors in large UK companies”. The 50 large UK companies reporting in 2005 were randomly drawn from the FTSE-250 listing. It was fund that - a total of 17 companies fully complied throughout their reporting year. Twenty-two companies took action to comply or proffered “acceptable” explanations as to why not during their reporting year. Eleven companies, however, remained in breach of the Code on one or more counts.
These findings clearly shows that not all companies are complying with the code. This raises the issue of non- executive independence amongst others.
Issue of non-executive “independence”
The provisions of the Code are aimed at giving a company's non-executive directors a greater influence over decision-making on the Board of Directors and its main Committees placing a particular emphasis on non-executives being “independent”. This, according to the Higgs Report which forms the basis of the new provisions, should provide for a greater impartiality and objectivity in decision-making, keep in check any likelihood of executive director “excesses” while ensuring shareholder interests are looked after (Higgs Report, 2003). These considerations are important in the context of attending to the “principal-agent” issue and it is significant that one of the main responsibilities of the senior independent non-executive is to liaise regularly between the company's directors and its shareholders to promote goal congruence (Jensen and Meckling, 1976).
However, is this confidence in the contribution which non-executives can make well placed?.
Supporters of the cause of non-executives such as Higgs point to their advantages, but there are some potential limitations (Pass, 2004; Weir and Lain, 2001). On the positive side non-executives can contribute valuable business experience and expertise. Typically, as is the case in the above survey companies, the majority of them are either current executive directors of other companies or are former executives. As such they are in a position to offer wise counselling and the benefits of their diverse experience to the company. Secondly, under the new provisions of the Code, they are in a strong position to challenge empire-building and policies promoted by the company's executives whom they feel are incompatible with shareholders interests (Pass, C.L. 2004).
Despite these apparent pluses, reservations have been expressed concerning the ability of non-executives to significantly influence company decisions. Non-executives perform their duties on an irregular basis meeting only a few times a year (Board meetings typically once a month and Committee work three to five times a year). As “part-timers”, it could be argued their limited involvement, familiarity with and time spent on company matters compromises their effectiveness. Moreover, non-executive directors who are full-time executives, or who hold a number of non-executive directorships with other companies may not be able to give the company their fullest attention. It could be argued, however, that although a non-executive's contact with the company in any one year is limited this may be counterbalanced by their continuing involvement with the company over a run of years, providing them with cumulative knowledge and familiarity of the company's affairs and thereby enhancing their contribution as time goes by. On the other hand, longevity of service can be challenged (as personified by the Codes new nine years limit guideline) on the grounds that it is likely to lead to an erosion of “independence” (FRC, 2006). On balance as has now found expression in the main provisions of the Code, the presence of a robust team of non-executives directors is seen as an important contributory factor to effective governance practice (Pass, C.L. (2004).
Regarding the implementation of the new Code most of the problems which have arisen concerning the comply or explain requirement is down to the “independency” issue. The Code lists a number of criteria which renders a non-executive as being “not independent” but permits companies to override this if it can be shown that a non-executive director is “independent in character and judgement” (FRC,2006). According to Pass, (2004) there must be serious reservations about the independence of someone who has a business relationship with the company, and it could be recommended that such persons should be excluded from serving as a non-executive director to remove any ambiguity. It is the Board which decides whether an individual is indeed independent and this involves an element of subjectivity.
Regarding the chairperson (even non-executive chairpersons) the Code is adamant that their pivotal position in organizing and directing the work of the Board renders them “not independent”. Although they are permitted to sit on the Nominations Committee (provided that is they do not compromise the majority of independent non-executive membership provision), they are expressly excluded by the Code from being members of the Remuneration and Audit Committees. However, as the survey has revealed, many companies have not been prepared to accept the legitimacy of this exclusion (Pass, 2004).
Big question marks often surround the impartiality of non-executives who have an on-going business relationship with the company, either because they sit on the board of an affiliated company, or provide the company with consultancy and other advisory services for a fee.
Significantly, however, the concept of independence has been stretched to include also long-serving non-executive directors, specifically declaring non-executives who have served the company nine years or more to be “not independent”. Why nine years – why not eight years or ten years? The issue of longevity can be looked at in two ways – positively or negatively. Long-serving non-executives may remain totally objective in their views and behaviour and, in particular, as noted above their continued involvement in the affairs of the company over a long period of time may well enhance the effectiveness of their contribution to the work of the Board and its Committees. Conversely, long-serving non-executives may become too subservient and too dependent on executive patronage (for example nomination for their re-election as a non-executive) that they are less likely to “rock-the-boat” and oppose executive directors policies and decisions (Pass, 2004).
The development of corporate governance in the UK is the result of the regulators ( accounting profession), principally reacting to the public’s perception of these problems. The profession has so far continued with self-regulation, attempting to overcome its weakness instead of going for statutory regulation. For how long then will self regulation continue? Are we going to have other WorldCom?.
We also need to ask whether the effort of producing the various reports was worth it, so that we can identify what needs to be done to resolve any remaining / new corporate governance problems.
Conclusion
Corporate governance is complex. The development of corporate governance in the UK is the result of the regulators ( accounting profession), principally reacting to the public’s perception of these problems.
The new provisions introduced with the Combined Code were especially concerned to provide greater empowerment of a company's non-executive directors in top-level decision-making, with a particular emphasis on non-executives being “independent” according to criteria specified in the Code.
Based on the survey by Pass in most of the cases the “problem” has cantered on the status of the chairperson, with companies refusing to accept the Code's strict dictum that a chairperson is not independent as a member of the Remuneration and Audit Committees. In addition to this, the issue of independence has arisen in a number of other cases in relation to the nine years and business connection Code criteria. In all of these cases companies have claimed that the non-executives concerned have been “independent in character and judgement”. This contention may well be “acceptable” when applied to long-serving non-executives, but is clearly suspect in the case of non-executives having a business relationship with the company.
The big question is whether non-executives can really play a decisive role in company affairs. Most commentators have looked on the provisions of the new code as a force for good, facilitating more impartial decision-making and greater attention to shareholder interests.
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