The role of the non-executive director
| by Peter Atrill 30 Nov 2006 Diploma in Financial Management Relevant to Module B |
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The boards of public limited companies usually have a mixture of executive and non-executive directors. Executive directors are normally full-time officers of the company and are given particular responsibilities relating to the management of the business. These responsibilities often relate to a particular business function such as marketing, production, finance or personnel. In contrast, non-executive directors are normally employed on a part-time basis and do not have responsibilities for particular functions or for operational matters. They have a broader role that involves contributing towards the development of a clear mission and strategy for the company and for ensuring that the strategic objectives are fulfilled.
The role of the non-executive director also involves monitoring the decisions and actions of the executive directors to ensure that the interests of the shareholders are being pursued. This monitoring role has taken on increased significance following recent corporate governance scandals and the publication of the Cadbury Report. Indeed, the Hampel Report suggested that the Cadbury Report might have overemphasised this role. Non-executive directors are increasingly urged to demonstrate their independence and to challenge the decision of the executive directors, bringing to their attention poor performance or areas that require improvement.
The roles of executive and non-executive directors are quite different in nature, they nevertheless have the same legal obligations towards the shareholders of the company, including acting in their best interests. Recently, non-executive directors of failing businesses have been subjected to legal action. For example, the directors of Equitable Life, including the non-executive directors, are currently being sued for £2.9 billion for causing policyholders a substantial loss of benefits (see Reference 1). Not surprisingly, some companies are finding it necessary to offer insurance cover to prospective non-executives to entice them to join the board.
Non-executive directors should bring some independence of thought and objectivity to the boardroom. These qualities are often of particular value when the company is experiencing serious problems and the executive directors find it hard to detach themselves from the immediate and pressing issues that consume them. In these circumstances, the non-executive directors can help to bring some perspective to the problems that are being faced. However, even when the company is not in crisis, non-executive directors should make valuable contributions towards key issues. They are often appointed because they have a sound understanding of business and a proven track record in managing a business. They should be able to advise the executive directors on matters such as appraising new investment opportunities; dealing with threats to business activities; measuring and evaluating business performance and implementing proper control systems. Some non-executive directors have a wide network of business connections, which may prove invaluable in helping the executive directors to establish new contacts and thereby create new opportunities for the company.
Criticisms of the role
In recent years, the role of the non-executive director has been criticised. One criticism is that the duties of non-executive directors cannot be easily reconciled. On the one hand, they are expected to contribute towards developing appropriate strategies for the company, which involves working closely with the executive directors as part of a team. On the other hand, they are expected to monitor the executive directors’ behaviour and to challenge their decisions. This requires that a certain distance be maintained in order to ensure independence. Although it may be possible to carry out both these tasks successfully, it does require that a delicate balance be struck and this may prove to be beyond the abilities of many non-executive directors.
Risks to the independence of non-executive directors have been much debated in recent years. These risks may arise from their relationship with the executive directors. Executive directors usually exert an influence over who becomes a non-executive director of the company and this may lead non-executive directors to feel obliged to the executive directors for their job. In addition, there may be crossholdings of directorships and strong social links between executive and non-executive directors, which may result in friendship prevailing over the shareholders’ interests.
This has led to the rather biting criticism that non-executive directorships are often little more than posts involving minimal duties for ageing executives and that the close bonds that exist between non-executive directors result in a ‘cosy’ consensus of views within the boardroom. Some believe that even where non-executive directors start out by being independent, the close involvement with the executive directors over time ultimately results in a less independent approach.
Risks to the independence of non-executive directors can also arise where the non-executive directors have a significant financial interest in the business apart from the directors’ fees that are paid. This interest may arise from participation in share option schemes that are run by the company, receiving fees from the company for other duties carried out, or significant business relationships with the company.
Potential difficulties encountered by non-executive directors in carrying out their duties effectively have also been the subject of debate. There is a risk that executive directors may try to impose restrictions on their non-executive colleagues. It is possible that executive directors will wish to avoid close scrutiny of their actions and so will not provide the non-executives with all relevant information necessary to form a proper judgement. It has also been suggested that non-executive directors may find it difficult to identify or pursue issues because of competing claims on their time. Many are full-time executive directors of other public companies and may hold several other non-executive director appointments.
Dealing with the criticisms
There are various ways in which the criticisms that have been mentioned may be tackled. It has been suggested that independence would be helped if large shareholders were involved in the recruitment and selection of non-executives. It has also been suggested that regular meetings between non-executive directors and shareholders would help them to understand the key issues and to retain their independence over time. However, this latter idea has received mixed responses from the business community, as some believe that it could lead to misunderstandings.
It has been argued that non-executives often have insufficient grasp of the detail surrounding particular issues and this may cause communication problems at meetings. Where non-executive directors are prepared to take a stand against executive directors on particular matters, there must be safeguards in place to ensure that such action is not penalised in some way.
To ensure access to all relevant information, non-executives must be properly represented on the key committees of the board such as the
The increasing complexity of business and the increasing responsibilities placed on non-executive directors means that more time must be devoted to the role. As a consequence, there must be increased compensation in order to recruit and retain able non-executives. According to New Bridge Street Consultants, the median fee for a non-executive director of a FTSE 100 company is £37,000 per year for about 30 days work per year (see Reference 1). Some argue, however, that this figure should be significantly higher to reflect the additional burdens that have been imposed. It has also been suggested that there should be some restriction on the number of non-executive appointments that an individual can hold.
The Higgs report
The Higgs Report on the role of non-executive directors has recently been published. This report, which was commissioned by the government, seeks to build on best practice and adopts the ‘comply or explain’ approach of previous corporate governance reports in an effort to retain flexibility. The main recommendations of the report cover four broad areas:
- the balance of power within the board
- communications
- the terms of non-executive directorships
- the selection of non-executive directors.
In the first of these broad areas, there is a recommendation that at least half the membership of the board of directors, excluding the chairman, should be made up of non-executive directors. Although this recommendation appears to have considerable support, there are those who believe that it represents a dilution of executive power within the boardroom and will lead to an increase in the size of the boards, which, in turn, will make them unwieldy.
The second recommendation is that the chief executive of a company should not become chairman of that company. This reflects the view that the roles of chairman and chief executive should be kept separate and where the chairman was previously the chief executive, this separation can become much more difficult. The temptation for the previous chief executive to intervene in the current chief executive’s decision-making may prove too great, leading to a confusion of roles.
The second broad area deals with communications with shareholders and communications between non-executive board members. It is recommended that a senior independent director should be appointed to act as a ‘listening post’ for shareholders who may wish to raise issues that they do not feel are being properly addressed by the chairman or chief executive.
To gain direct contact with shareholders, the senior independent director is expected to join the regular meetings that the executive directors have with large shareholders. This recommendation is probably the most contentious of all those mentioned in the report. It has been argued that this recommendation is potentially divisive and could threaten the unity of the board. Nevertheless, the recommendation should provide non-executive directors with a much clearer view of the issues that concern the shareholders. Communication between non-executive directors is encouraged and the report recommends that non-executives should meet together at least once a year without the executive directors or chairman in attendance.
The third broad area includes a number of recommendations concerning the ways in which the terms of non-executive directorships may help to make the role more effective. It is recommended that non-executives should be expected to serve two three-year terms of office, although in exceptional circumstances this can be increased to three terms. This recommendation should help to ensure that the board is re-invigorated at reasonable intervals and the independence of the non-executive directors is maintained.
Although the report makes it clear that the non-executive directors must ensure that they have time to fulfil their role, there is no attempt to set limits on the number of non-executive directorships that can be held by an individual, as was widely expected. However, the report does recommend that full-time executives should take no more than one non-executive directorship and that the chairman of a major company should not simultaneously chair another major company.
The final area concerns the selection of non-directors. It has been suggested that the typical non-executive is pale, male, stale and already on a FTSE 100 company’s board, see reference 3. The Higgs Report recommends that companies should look further afield for their non-executives. Moreover, to help avoid the criticism of an ‘old boy network’ being in operation, there should be more formal and transparent methods used in recruiting and selecting candidates.
References
1 The board game, Business Focus, The Sunday Times, p5,
2 op.cit
3 Lex column: The width of the pool, Financial Times, p20,