United Kingdom

Author: | Published: 9 Oct 2003
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

A new Combined Code for the UK was issued by the Financial Reporting Council on July 23 2003 and will apply to listed UK companies for financial years ending on or after November 1 2003.

After all the heated debate, how much does this new Code differ from the proposals in the Higgs report? Not much. While some of the main points of contention have been addressed, the Code still contains most of the key recommendations from the report.

But, many of the original proposals are now to be found in supporting principles rather than actual Code provisions, allowing companies greater flexibility in implementing the Code. One of the main criticisms of Higgs' recommendations was that it included too many provisions which, it was felt, would encourage a box-ticking approach rather than allowing companies the ability to comply or explain. The comply or explain principle is reinforced in the preamble to the new Code which states that companies' explanations "should not be evaluated in a mechanistic way and departures ... should not automatically be treated as breaches". Institutional shareholders will be required to discuss any non-compliance with a company where not satisfied with the company's explanation and are expected to take a measured approach to any non-compliance.

In practice, this should result in a more flexible approach being adopted, but will also result in companies having to make greater disclosure in their annual report and accounts. They will now have to explain how they have applied the main principles and the new supporting principles.

INCREASE IN BOARD SIZE

For many companies there will need to be an increase in the number of independent non-executives on the board to ensure a majority of independent non-executive directors (excluding the chairman) rather than one-third being non-executives, a majority of whom have to be independent. Smaller companies -those outside the FTSE 350 - only need to have two independent non-executive directors rather than a majority.

Companies will also need to consider whether their non-executives are independent, applying the new definition of independence - namely, whether each is independent in character and judgment and whether there are any relationships or circumstances (including those listed in the Code) which are likely, or could appear to affect, their judgment. This is particularly the case where a company has long-term non-executives. Although non-executives can serve for more than nine years (subject to annual election), the Code notes this may impact on their independence. Indeed, the Code states that any term beyond six years should be subject to "particularly rigorous review".

Other than smaller companies, all companies will need at least three independent non-executive directors to comply with the requirements for membership of the audit and remuneration committees. And one of those directors must have "recent and relevant financial experience". The requirement that a non-executive cannot not sit on all three committees has been dropped and smaller companies need only have two independent non-executives on each committee.

All companies will also now need to establish a nomination committee. While the chairman cannot be a member of the audit or remuneration committee he can be a member of, and is allowed to chair, the nomination committee.

ROLE OF THE CHAIRMAN

The chairman's role has been increased to include leadership of the board; ensuring that directors receive accurate, timely and clear information (and management have an obligation to provide it); ensuring effective communication with shareholders; ensuring effective contribution of the non-executives and constructive relations between the non-executive and executive directors; responsibility for induction and development of directors and for evaluating the performance of the other board members. The chairman should no longer also be chief executive and there must be a clear division of responsibilities between the two. The chairman's responsibility to ensure that various matters occur is absolute in nature and risks being a smoking gun in any regulatory investigation or litigation if, despite reasonable care, the chairman fails. Recent litigation in Australia indicates that these absolute words can be used against a chairman when things go wrong.

The Code restricts who can be appointed as chairperson by requiring that the chairman meet the test of independence on appointment. Former chief executives of the company should not go on to become chairman other than in exceptional circumstances, in which case large shareholders must be consulted and the reasons for the appointment given at the time of appointment and in the annual report. To ensure that the chairman can devote sufficient time to his or her increased responsibilities, FTSE 100 companies should not appoint someone who is already chairman of another FTSE 100 company, nor someone who is a full-time executive director of another company.

SENIOR INDEPENDENT DIRECTOR'S ROLE

The revised Code clarifies the roles of the senior independent non-executive director and the chairman, thereby removing the potential for conflict between the two, so that the senior independent director's role will continue much as it has to date. The Code makes it clear that the chairman has primary responsibility for ensuring that shareholders' views are communicated to the board. The senior independent director will attend meetings with shareholders to listen to their views with the aim of gaining a better understanding of their concerns. The senior independent director is only available to shareholders where their concerns cannot be resolved through the normal contacts (chairman, chief executive or finance director) or where this contact is inappropriate, thus, ensuring he or she has a reactive role, rather than a more proactive role as some interpreted from the Higgs report.

GREATER TIME COMMITMENT

The Code includes the new broad description of the roles and responsibilities of non-executive directors. These include challenging and developing strategy, monitoring performance, risk assessment, responsibility for the level of executive director remuneration, appointment of executive directors and succession planning. The roles and responsibilities of the nomination committee are substantially increased including ensuring that a more transparent and rigorous appointment process is implemented.

The audit committee's role and responsibilities are greatly enhanced. It must monitor the integrity of financial information; review internal financial controls on risk management systems; monitor and review the effectiveness of the internal audit function; monitor the external auditor's independence; and develop the company's policy for using the external auditor for non-audit services. It must also be responsible for reviewing the company's whistleblowing procedures.

A higher standard of care will be required from non-executive directors in relation to financial controls. They will have to satisfy themselves that the financial controls and systems of risk management are robust and defensible. The Turnbull guidance on internal control (which is now annexed to the Code) only requires them to satisfy themselves that the financial controls "provide reasonable assurance against material misstatement or loss".

These increased responsibilities will require non-executives to devote more time to their roles if they are to carry them out effectively. Not only must they have time to review board/committee papers and attend meetings, they must also be able to set aside time for induction, professional development, understanding the company's business succession planning and discussions with shareholders. The increased time commitment is illustrated by the fact that, on appointment, non-executives must undertake that they have enough time to meet what is expected of them. The annual evaluation of directors' performance also includes an assessment of whether non-executive directors are devoting enough time to fulfilling their role.

My view is that non-executive directors' fees should increase to reflect the greater commitment required. Some of this remuneration could be in shares (which the Code does permit, if not explicitly) but should not be in share options, except in exceptional circumstances or with shareholders' approval.

INCREASED LIABILITY

These additional responsibilities mean that non-executives' potential reputational risk and legal liability is increased. This, in part, reflects that any Code complaint board decision of a FTSE 350 company can be passed by a majority comprised of non-executive directors. Annexed to the Code is guidance to assist non-executive directors in determining what care, skill and diligence is expected of them. This confirms and raises the standards required of non-executive directors. The guidance also highlights the fact that it is up to each director to decide what is needed for him or her to comply with the duty of care, skill and diligence as a director. Non-executives will have to play a more proactive role; being willing to assist in developing the company's strategy while monitoring and, where necessary, challenging actions taken by the executives.

CONCLUSIONS

All this should be viewed in conjunction with a trend to increase the number of offences increasing the likelihood of personal liability on directors who have not managed in a socially acceptable manner. Increased and more meaningful compliance with the Code should however, provide greater protection for directors and thus should be viewed positively.

The revised Code will bring over time a step change in UK corporate governance. If fully implemented, it will dramatically increase the number of non-executives appointed and will have a significant impact on the role of chairmen.

The above article is general in nature. Specific advice should be sought in individual circumstances. For information on other legal developments (including e-mail updates), visit www.elexica.com, the award winning on-line legal resource powered by knowledge from Simmons & Simmons.

For other information on the Higgs report and on corporate governance issues, visit www.elexica.com, or contact the author on charles.mayo@simmons-simmons.com.


Simmons & Simmons
CityPoint
One Ropemaker Street
London EC2Y 9SS
Tel: +44 207 628 2020
Fax: +44 207 628 2070
www.simmons-simmons.com