Chapter 3: The board of directors

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain and evaluate the roles and responsibilities of boards of directors
• describe, distinguish between, and evaluate the cases for and against, unitary and two-tier board structures
• describe the characteristics, board composition and types of directors, including defining executive directors and non-executive directors (NEDs)
• describe and assess the purposes, roles and responsibilities of NEDs
• describe and analyse the general principles of legal and regulatory frameworks within which directors operate on corporate boards:
  • legal rights and responsibilities
  • time-limited appointments
  • retirement by rotation
  • service contracts
  • removal
  • disqualification
  • conflict and disclosure of interests
  • insider dealing/trading
• define, explore and compare the roles of the chief executive officer (CEO) and company chairman
• describe and assess the importance and execution of induction and continuing professional development (CPD) of directors on boards of directors
• explain and analyse the frameworks for assessing the performance of boards and individual directors (including NEDs) on boards
• explain and assess the importance, roles and accountabilities of board committees in corporate governance
• explain and evaluate the role and purpose of the following committees in effective corporate governance:
  • nominations committees.

1 Development of corporate governance regarding the board of directors

As discussed in chapter 2 the development of corporate governance codes is closely associated with the UK. Here we will look at the three reports that contributed to the existing code with regards to the board of directors.

Illustration 1 – Maxwell and Mirror Group Newspapers

In 1991 the body of Robert Maxwell was found off the Canary Islands. The investigation that followed his death led to one of the most shocking revelations to hit British business for many years, and the collapse of several high profile listed companies.

The key to the 'success' of Maxwell's deception was his unrivalled position on the boards of his many companies (he combined the role of chairman and chief executive at Mirror Group Newspapers, which placed him in an extremely powerful position; his companies had no non-executive directors, which silenced any potential dissenting voices; he also had single authority over the pension fund, which allowed him to use the fund as collateral for ever increasing borrowings), allowing him to make decisions that were in his own interests rather than those of shareholders.

In response, the Cadbury Report highlighted a wide range of measures that companies should take, including splitting the role of chairman and chief executive to prevent one individual having 'unfettered power', and having a board consisting of executive and non-executive directors, resulting in the birth of Corporate Governance as we see it today.

Cadbury Report (1992)

This report concluded that the board required constant monitoring and assessment.

Recommendations were:

• there was a need to split the chairman/CEO role
• necessary to ensure the chairman is an independent person at the time of appointment.

Higgs Report (2003)

This report came about post-Enron and focused on the role of non-executive directors (NEDs). It is the role of NEDs to represent the needs of shareholders and operate as a cautionary voice on the board.

Conclusions included:

• at least half the board should be made up of NEDs
• they should be remunerated appropriately for taking on a functional role
• they should act as a link between the board and shareholders to reduce the agency problem
• they should communicate regularly to important shareholders.

Tyson Report (2003)

This developed from the Higgs Report. It dealt with the recruitment and development of NEDs.

Conclusions included:

• the need to expand the gene pool of NEDs beyond reciprocal arrangements between top PLCs
• diversity in background, skills and experience enhanced board effectiveness (agency issue)
• diversity improved communication and relationships with stakeholders including shareholders
• stakeholders on the board improved board understanding of stakeholder issues.

Financial Reporting Council - FRC (2010)

In May 2010 the FRC issued a new edition of the Code which will apply to financial years beginning on or after 29 June 2010.

This follows a review of the Code carried out during 2009 and consultation on a draft of the revised Code that ended in March 2010

The main four revisions of the 2010 Code are:

(1)The FRC announced that the Code would in future be known as the UK Corporate Governance Code.

(2)Section A in the 2008 Code has been divided into two new sections called "Leadership" and "Effectiveness" (Sections A and B in the 2010 Code)

(3)Four new principles

• The chairman's responsibility for leading the board (New Principle A.3);
• The non-executive directors' role in challenging and developing strategy (New Principle A.4);
• The need for the board to have a balance of skills, experience, independence and knowledge of the company (New Principle B.1); and
• The need for all directors to have sufficient time to discharge their responsibilities effectively (New Principle B.3).

(4)The provisions on re-election of directors have been revised to state that all directors in FTSE 350 companies should be put forward for re-election every year (Provision B.7.1).

2 Board of directors – roles and responsibilities

In relation to corporate bodies:

• a director is an officer of the company charged by the board of directors with the conduct and management of its affairs
• the directors of the company collectively are referred to as a board of directors
• the shareholders appoint the chairman of the board and all other directors (upon recommendations from the nominations committee)
• directors, individually and collectively, as a board of directors, have a duty of corporate governance.

From the principles in the UK Corporate Governance Code (2010), the key roles and responsibilities of directors are to:

• provide entrepreneurial leadership of the company
• represent company view and account to the public
• decide on a formal schedule of matters to be reserved for board decision
• determine the company's mission and purpose (strategic aims)
• select and appoint the CEO, chairman and other board members
• set the company's values and standards
• ensure that the company's management is performing its job correctly
• establish appropriate internal controls that enable risk to be assessed and managed
• ensure that the necessary financial and human resources are in place for the company to meet its objectives
• ensure that its obligations to its shareholders and other stakeholders are understood and met
• meet regularly to discharge its duties effectively
• for listed companies:
  • appoint appropriate NEDs
  • establish remuneration committee
  • establish nominations committee
  • establish audit committee
• assess its own performance and report it annually to shareholders
• submit themselves for re-election at regular intervals. All directors in FTSE 350 companies should be put forward for re-election every year

The UK Corporate Governance Code (2010) has been developed as a source of good practice. Although it is not global in its application it remains a useful guide for examination purposes.

Effective board

An effective board demonstrates the following capabilities:

• clear strategy aligned to capabilities
• vigorous implementation of strategy
• key performance drivers monitored
• sharp focus on the views of the City and other key stakeholders
• regular evaluation of board performance.

Directors' skills

Directors' characteristics and skills

There are many characteristics and skills required to be a 'good' director of a company and some of the key ones are:

Example of job description/role – finance director

The job description and role will vary according to the size of the company involved. However, in general, he/she:

• oversees all financial aspects of company strategy
• is responsible for the flow of financial information to the CEO, the board and, where necessary, external parties such as investors or financial institutions.

The main responsibilities of the job will entail some or all of the following:

• overall control of the company's accounting function
• financial planning and related ongoing advice for the CEO and senior management
• formulating financial targets and budgets in accordance with board-determined strategy
• overall control of all financial transactions and accountancy matters
• managing company policies on capital requirements, equity, debt, taxation, etc.
• preparing annual accounts
• ensuring that all regulatory requirements are met regarding all the company's financial affairs.

Potential problems for boards

Sometimes achieving all of this in practice can be difficult due to 'barriers'.

• Most boards largely rely on management to report information to them (and may not have the time or the skills to understand the details of company business), thus allowing management to obscure problems and the true state of a company.
• A board that meets only occasionally may be unfamiliar with each other. This can make it difficult for board members to question management.
• CEOs often have forceful personalities, sometimes exercising too much influence over the rest of the board.
• The current CEO's performance is judged by the same directors who appointed him/her making it difficult for an unbiased evaluation.

3 Board meetings

Practical suggestions for board meetings include:

• Agenda should strike a balance between long- and short-term issues and every director should have the opportunity to place items on the agenda.
• All topics should have informative supportive information, risks and alternatives identified. Information must be distributed in good time.
• Meetings should be regular and attendance expected.
• Chairmen should direct proceedings allowing ample time for discussion and input from everyone prior to decisions being made.
• Where necessary board away-days to strategic sites, or supportive strategy briefing meetings should be used.

Board agenda items

A board agenda is likely to include the following:

Companies Act requirement

• Approval of interim and final financial statements.
• Approval of interim dividend and recommendation for final dividend.
• Approval of significant changes to accounting policies.
• Appointment or removal of key staff such as company secretary.
• Remuneration of auditors (where shareholders have delegated the power).
• Recommendation for the appointment or removal of auditors (where shareholders have delegated the power).

Stock exchange

• Approval of press releases concerning significant matters decided by the board.

Management

• Approval of group's commercial strategy.
• Approval of group's annual operating budget.
• Approval of group's annual capital expenditure plan.
• Changes relating to the group's capital structure.
• Terms and conditions/service agreements of directors.
• Major changes to the group's management and control structure.

4 Board structures

There are two kinds of board structure, unitary and two-tier (dual) boards.

Two-tier boards

These are predominantly associated with France and Germany. Using Germany as an example, there are two main reasons for their existence:

• Codetermination: the right for workers to be informed and involved in decisions that affects them. This is enshrined in the Codetermination Act (Germany) 1976.
• Relationships: banks have a much closer relationship with German companies than in the UK. They are frequently shareholders, and other shareholders often deposit their shares and the rights associated with them with their banks.

This creates a backdrop to creating structures where these parties are actively involved in company affairs, hence the two-tier structure.

Lower tier: management (operating) board

• responsible for day-to-day running of the enterprise
• generally only includes executives
• the CEO co-ordinates activity.

Upper tier: supervisory (corporate) board

• appoints, supervises and advises members of the management board
• strategic oversight of the organisation
• includes employee representatives, environmental groups and other stakeholders' management representatives (these NEDs are not considered to be 'independent NEDs')
• the chairman co-ordinates the work
• members are elected by shareholders at the annual general meeting (AGM)
• receives information and reports from the management board.

Advantages of a two-tier board

• Clear separation between those that manage the company and those that own it or must control it for the benefit of shareholders.
• Implicit shareholder involvement in most cases since these structures are used in countries where insider control is prevalent.
• Wider stakeholder involvement implicit through the use of worker representation.
• Independence of thought, discussion and decision since board meetings and operation are separate.
• Direct power over management through the right to appoint members of the management board.

Problems with a two-tier board

• Dilution of power through stakeholder involvement.
• Isolation of supervisory board through non-participation in management meetings.
• Agency problems between the two boards.
• Added bureaucracy and slower decision making.
• Reliant upon an effective relationship between chairman and CEO.

Additional advantages of a unitary board

Issues specific to the unitary board tend to relate to the role of NEDs.

• NED expertise: the implied involvement of NEDs in the running of the company rather than just supervising.
• NED empowerment: they are as responsible as the executives and this is better demonstrated by their active involvement at an early stage.
• Compromise: less extreme decisions developed prior to the need for supervisory approval.
• Responsibility: a cabinet decision-making unit with wide viewpoints suggests better decisions.
• Reduction of fraud, malpractice: this is due to wider involvement in the actual management of the company.
• Improved investor confidence: through all of the above.

5 Non-executive directors (NEDs)

The key roles of NEDs

Strategy role: this recognises that NEDs have the right and responsibility to contribute to strategic success, challenging strategy and offering advice on direction.

Scrutinising role: NEDs are required to hold executive colleagues to account for decisions taken and results obtained.

Risk role: NEDs ensure the company has an adequate system of internal controls and systems of risk management in place.

People role: NEDs oversee a range of responsibilities with regard to the appointment and remuneration of executives and will be involved in contractual and disciplinary issues.

An effective NED

To be effective, a NED needs to:

• build a recognition by executives of their contribution in order to promote openness and trust
• be well-informed about the company and the external environment in which it operates
• have a strong command of issues relevant to the business
• insist on a comprehensive, formal and tailored induction, continually develop and refresh their knowledge and skills to ensure that their contribution to the board remains informed and relevant
• ensure that information is provided sufficiently in advance of meetings to enable thorough consideration of the issues facing the board
• insist that information is sufficient, accurate, clear and timely
• uphold the highest ethical standards of integrity and probity
• question intelligently, debate constructively, challenge rigorously and decide dispassionately
• promote the highest standards of corporate governance and seek compliance with the provisions of the Combined Code wherever possible.

Independence

The Code states as a principle that the board should include a balance of NEDs and executives. This is to reduce an unfavourable balance of power towards executives.

The board should consist of half independent NEDs excluding the chair.

One NED should be the senior independent director who is directly available to shareholders if they have concerns which cannot or should not be dealt with through the appropriate channels of chairman, CEO or finance director.

Reasons for NED independence

• To provide a detached and objective view of board decisions.
• To provide expertise and communicate effectively.
• To provide shareholders with an independent voice on the board.
• To provide confidence in corporate governance.
• To reduce accusations of self-interest in the behaviour of executives.

Threats to independence

Cross directorship

A cross directorship is said to exist when two (or more) directors sit on the boards of the other. In most cases, each director's 'second' board appointment is likely to be non-executive.

For example, director A is an executive director on the board of company X and also holds a non-executive position on the board of company Z. Director B is an executive on the board of company Z and also holds a non-executive position in company X.

Cross directorships could undermine the NED independence in that a director reviewing performance of a colleague who, in turn, may play a part in reviewing his or her own performance, is a clear conflict of interests. Neither director involved in the arrangement is impartial and so a temptation would exist to act in a manner other than for the benefit of the shareholders of the company on whose board they sit. 

In practice, such arrangements may also involve some element of cross shareholdings which further compromises the independence of the directors involved.

It is for this reason the cross directorships and cross shareholding arrangements are explicitly forbidden by many corporate governance codes of best practice.

NEDs on the board

Advantages

• Monitoring: they offer a clear monitoring role, particularly on remuneration committees to dampen the excesses of executives.
• Expertise: to expand this resource available for management to use.
• Perception: institutional and watchdog perception is enhanced because of their presence.
• Communication: the implied improvement in communication between shareholders' interests and the company.
• Discipline: NEDs may have a positive influence on the success or otherwise of takeovers.

Disadvantages

• Unity: lack of trust and needless input can affect board operations.
• Quality: there may be a poor gene pool of NEDs willing to serve.
• Liability: the poor remuneration with the suggested (Higgs) removal of stock options from the package coupled with the equal liability in law for company operations might lead some to question whether they want the job or not.

6 Chairman and CEO

Responsibilities

It is vital for good corporate governance to separate the roles of CEO and chairman.

The division of responsibilities between the chairman and CEO should be clearly established, set out in writing and agreed by the board.

The importance of the appointments of CEO and chairman are further underlined by the fact that the CEO frequently has most say over the appointment of executive directors to the board, while the chairman will frequently have a great deal of influence over the appointment of NEDs.

Chairman's responsibilities

The overall responsibility of the chairman is to:

• ensure that the board sets and implements the company's direction and strategy effectively, and
• act as the company's lead representative, explaining aims and policies to the shareholders.

Specific responsibilities of the chairman

The specific responsibilities of the chairman, inter alia, are to:

• provide leadership to the board, supplying vision and imagination, working closely with the CEO
• take a leading role in determining the composition and structure of the board which will involve regular assessment of the:
  • size of the board
  • balance between executive directors and NEDs
  • interaction, harmony and effectiveness of the directors
• set the board's agenda and plan board meetings
• chair all board meetings, directing debate toward consensus
• ensure the board receives appropriate, accurate, timely and clear information
• facilitate effective contribution from NEDs
• hold meetings with the NEDs, without the executive directors present
• chair the AGM and other shareholders' meetings, using these to provide effective dialogue with shareholders
• discuss governance and major strategy with the major shareholders
• ensure that the views of shareholders are communicated to the board as a whole.

CEO's responsibilities

The overall responsibility of the CEO is to:

• take responsibility for the performance of the company, as determined by the board's strategy
• report to the chairman and/or board of directors.

Specific responsibilities of the CEO

The specific responsibilities of the CEO, inter alia, are to:

• develop and implement policies to execute the strategy established by the board
• assume full accountability to the board for all aspects of company operations, controls and performance
• manage financial and physical resources
• build and maintain an effective management team
• put adequate operational, financial, planning, risk and internal control systems in place
• closely monitor operations and financial results in accordance with plans and budgets
• interface between board and employees
• assist in selection and evaluation of board members
• represent the company to major suppliers, customers, professional associations, etc.

Splitting the role

The UK Corporate Governance Code (2010) is unequivocal with regard to the separation of the chairman and CEO roles:

'A clear division of responsibilities must exist at the head of the company. No individual should have unfettered power of decision.'

Chairman should be independent in the same way that NEDs are designated as being independent. If not, reasons must be clearly disclosed to major shareholders.

The code states the Chairman should, on appointment, meet the independence criteria set out in the provisions, but thereafter the test of independence is not appropriate to the Chairman.

Reasons for splitting the role

• Representation: the chairman is clearly and solely a representative of shareholders with no conflict of interest having a role as a manager within the firm.
• Accountability: the existence of the separate chairman role provides a clear path of accountability for the CEO and the management team.
• Temptation: the removal of the joint role reduces the temptation to act more in self-interest rather than purely in the interest of shareholders.

Reasons against splitting the role

• Unity: the separation of the role creates two leaders rather than the unity provided by a single leader.
• Ability: both roles require an intricate knowledge of the company. It is far easier to have a single leader with this ability rather than search for two such individuals.
• Human nature: there will almost inevitably be conflict between two high-powered executive offices.

Test your understanding 1

Three years ago, the outgoing CEO/chairman of BrightCo decided to retire having served in the combined role for over ten years of a full 30 year BrightCo career. Succession was not an issue since Dan Bolowski had been operating as second in command for a number of years and had recently stepped firmly into "the old man's" shoes.

What followed was a roller coaster ride for investors, where the minor dips were more than compensated by the exhilarating rise in share price. Bolowski trebled the size of the company through his aggressive "slash and burn" acquisitive strategy, taking the company into uncharted markets around the globe where he bought, stripped and resold huge companies, reaping profits in the process.

The board of directors are rightfully pleased with their CEO's performance and the part they played in that success, seven out of ten board members being company executives. The remaining three were drafted in by the ex-CEO/chairman due to their key expertise in BrightCo's traditional markets. None have regular contact with shareholders. The board meets irregularly and (by their own admission) do not tend to do more than simply review current performance. Mr Bolowski has complete freedom to act and this is widely seen as the reason for the company's positive trading position.

Shareholders are also pleased with performance. However, some institutional investors have aired their concerns as to the sustainability of the current strategy, whether finances exist within BrightCo to support it and whether risks associated with unknown markets make the company overexposed and vulnerable.

At the last board meeting Mr Bolowski brushed aside any criticism stating that he was going to take the firm to new heights, a pronouncement met with loud applause from all those in attendance.

Required:

(a)With reference to the scenario, discuss changes to governance structure that you would recommend for this company.

(b)Assuming the changes recommended in part (a) are carried out, describe the possible role of a new board of directors.

7 Directors' induction and CPD

Induction

• Although aimed at NEDs, the principles of an induction programme will be the same for new executive directors coming to the company from another organisation.
• For an internally-promoted director, it will depend on the person's background as to which aspects of the programme must be undertaken.
• It is important, for effective participation in board strategy development, not only for the board to get to know the new NED, but also for the NED to build relationships with the existing board and employees below board level.

The induction process

Every company should develop its own formal induction programme and it should:

• be comprehensive
• be tailored to the needs of the company and individual directors
• contain selected written information plus presentations and activities such as meetings and site visits
• give new appointees a balanced and real-life overview of the company
• not overload the new director with too much information
• provide the new director with a list of all the induction information that is being made available to them so that they may call up items if required before these are otherwise provided.

The induction process should give the incoming director:

• an understanding of the nature of the company, its business and the markets in which it operates
• a link with the company's people
• an understanding of the company's main relationships (including meeting with the company's auditors).

Objectives of induction

• To communicate vision and culture.
• To communicate practical procedural duties.
• To reduce the time taken for an individual to become productive in their duties.
• To assimilate an individual as a welcome member of the board.
• To ensure retention of individuals for future periods.

Induction package

The company secretary is generally responsible for directors' induction. The Institute of Chartered Secretaries and Administrators (ICSA) induction package suggests the following items for immediate provision to the director.

Director's duties:

• Brief outline of director's role and responsibilities under codes of best practice.
• Advice on share dealing and disclosure of price sensitive information.
• Company information on matters reserved for the board, delegated authority, policy for obtaining independent advice.
• Fire drill procedures.

Company strategies:

• Current strategies, plans and budgets/forecasts.
• Annual accounts, interims and KPIs.
• Company structures, subsidiaries and joint ventures.
• Treasury issues such as financing and dividend policy.
• Company brochures, mission statements.

Board operations:

• Memorandum and articles.
• Minutes of 4-6 previous meetings.
• Board composition/profiles of members.
• Details of committees, meeting procedures and schedule for future meetings.

A few months later:

• Company's history plus products and services brochures.
• Details of advisors and contacts (lawyers, auditors, banks).
• Details of major shareholders and shareholder relations policy.
• Copies of AGM circulars from 3 previous years.
• Copies of management accounts.
• Details of risk management procedures and disaster recovery plans.
• Policies: health and safety, whistleblower, environmental, ethics and charitable.
• Recent press releases, reports, articles, cuttings.
• Details of five largest customers and suppliers.
• Full details of the code of compliance and company policy in relation to it.

Continuing Professional Development (CPD)

The following offers guidance on directors' CPD requirements:

• To run an effective board, companies need to provide resources for developing and refreshing the knowledge and skills of their directors, including the NEDs.
• The chairman should address the developmental needs of the board as a whole with a view to enhancing its effectiveness as a team.
• The chairman should also lead in identifying the development needs of individual directors, with the company secretary playing a key role in facilitating provision.
• NEDs should be prepared to devote time to keeping their skills up to date.

Objectives of CPD

• To ensure directors have sufficient skills and ability to be effective in their role.
• To communicate challenges and changes within the business environment effectively to directors.
• To improve board effectiveness and, through this, corporate profitability.
• To support directors in their personal development.

8 Legal and regulatory framework governing the board of directors

Legal rights and responsibilities

The legal duties of a director are a baseline for directorial action and a concern since breach can leave a director open to criminal prosecution and imprisonment (e.g. corporate manslaughter).

Objective

The law is there to protect the owners of the company. It exists because of the nature of a fiduciary relationship where one person acts on behalf of another. The law provides a framework for directors' actions in upholding the best principles in this owner/manager relationship.

Power

Directors do not have unlimited power.

• Articles of association: the articles of association provide a framework for how directors operate including the need to be re-elected on a 3-year rotation.
• Shareholder resolution: this curtails director action in a legal sense.
• Provisions of law: these could be health and safety or the duty of care.
• Board decisions: it is the board that makes decisions in the interests of shareholders, not individual directors, but rather a collective view.

Directors do however have unlimited liability in the sense that even though they may delegate actions to management below, in a legal sense they cannot delegate liability for the outcome.

Fiduciary duties

Being aware of the objective and the power vested in directors leads to consideration of the nature of the fiduciary relationship.

• The duty to act in good faith: as long as directors' motives are honest and they genuinely believe they are acting in the best interests of the company they are normally safe from claims that they should have acted otherwise.
• The duty of skill and care: this care is a specific fiduciary duty. The law requires a director to use reasonable skill and care in carrying out their tasks.

Penalties

Directors who breach duties may face civil action by the company. If the director is in breach:

• any contract made by the director may be void
• they may be personally liable for damages in compensation for negligence
• they may be forced to restore company property at their own expense.

In the UK (for example purposes only) offences occur under the Companies Acts 1985 and 2006.

There are over 250 offences with penalties ranging from fines to imprisonment. Most are dealt with at magistrates' courts and relate to:

• administrative and compliance issues such as those for filing accounts
• restrictions and disclosure requirements such as insider trading and disclosure of share interests.

Example of directors' duties

Historically, directors' duties have been owed almost exclusively to the company and its members, and the board was expected to exercise its powers for the financial benefit of the company. Recently there have been attempts to provide more scope for directors to act as 'good corporate citizens'. For example, in the UK, the Companies Act 2006 requires a director of a UK company 'to promote the success of the company for the benefit of its members as a whole', but sets out six factors to which a director must have regard in fulfilling this duty:

• likely consequences of any decision in the long-term
• interests of the company's employees
• need to foster the company's business relationships with suppliers, customers and others
• impact of the company's operations on the community and the environment
• desirability of the company maintaining a reputation for high standards of business conduct
• need to act fairly as between members of a company.

Appointment, retirement and removal of directors

Retirement by rotation

• At the first AGM all the directors retire.
• At each subsequent AGM, one-third of the directors are subject to retirement by rotation or, if their number is not three or a multiple of three, the number nearest to one-third retires.
• The directors to retire by rotation are those who have been longest in office since their last appointment or reappointment.
• Directors should be re-elected at least every three years.
• All directors in FTSE 350 companies should be put forward for re-election every year (Provision B.7.1).

More on retirement by rotation

If the company, at the meeting at which a director retires by rotation, does not fill the vacancy the retiring director shall, if willing to act, be deemed to have been reappointed unless:

• at the meeting it is resolved not to fill the vacancy or
• a resolution for the reappointment of the director is put to the meeting and lost.

New appointees are either recommended by existing directors or nominated by one/more shareholders. In any case, appointments must be confirmed by shareholder vote.

The main advantages of a system of retirement by rotation:

• ensure that all the directors do not retire at the same time thus creating a vacuum
• allow the shareholders an annual say in how the board of directors is composed
• give a vote of confidence (or otherwise!) on the performance of the board
• stagger the impact of contract termination costs
• increase director accountability for performance and reduce complacency
• provide an opportunity to replace the board in an orderly manner.

Director's service contract

This is a legal document covering the terms of service (employment) of a company director. It includes:

• key dates
• duties
• remuneration details
• termination provisions
• constraints
• other 'ordinary' employment terms.

The notice or contract periods should be set at one year or less. If longer notice or contract periods to new externally-recruited directors need to be offered, such periods should reduce after the initial period.

Directors' service agreement

An executive director has certain rights and obligations arising as an employee as well as a director of a company. A director's service agreement should include, inter alia, the following key information:

• Appointment commencement date.
• Notice required by either party to terminate the agreement.
• Date of automatic termination (normal retirement date).
• Duties of the director.
• Limitations on the director in engaging in business or professional activities outside the employment.
• Remuneration details (including salary, bonus schemes, share options, medical insurance, life and disability insurance, pensions, company car and/or other benefits).
• Details of 'normal' employment issues (such as reimbursement of expenses, location of the director's main place of work, holiday entitlements, entitlements relating to sickness or accidents, etc.
• Provisions concerning disclosure of company information considered confidential.
• Provisions relating to intellectual property issues.
• Circumstances under which the service agreement may be terminated by the company without notice.
• Details of any constraints that may apply to the director on leaving the company (which may include working for a competitor, setting up in competition to the company, soliciting or dealing with company clients and poaching senior members of staff).
• Other provisions relating to the termination of the employment including the right for the company to give pay in lieu of notice and/or to place the director on gardening leave.
• Specification of which law governs the agreement (e.g. the law of Scotland).
• Evidence that the agreement has been approved by the board.

Removal of directors

NEDs should be appointed for specified terms subject to re-election and to Companies Act provisions relating to the removal of a director, and reappointment should not be automatic.

The office of director may be vacated by:

• resignation from office by notice, or without notice, to the company
• not offering self for re-election
• death in service
• personal bankruptcy, or other reasons for disqualification (see below)
• failure of the company
• being removed e.g. dismissed for disciplinary offences
• statute: under a provision in either the articles of association of the company or through shareholder resolution such as failure to be re-elected by rotation
• absence for more than six consecutive months, without permission of the directors, from meetings of directors held during that period and the directors resolve that the office be vacated
• an 'agreed departure'.

Company's constitution

Directors may be removed from the board if the company's constitution prevents them from serving if they are declared bankrupt. The constitution may lay down other exclusions from serving, such as mental illness or being absent without permission.

In the UK the company's constitution is enshrined in the articles of association. The articles may provide that a director can be removed from office in the following situations:

• by an extraordinary resolution (75% vote in favour) passed in an annual general meeting (AGM)
• by resolution of the board of directors
• by an ordinary resolution (50% votes in favour) where 28 days notice has been given to the company by the proposer of the resolution.

This statutory power overrides the articles and any service agreement that the director may have with the company, though the director may be entitled to compensation for its breach by dismissal.

Disqualification of directors

Potential causes of disqualification include:

• allowing the company to trade while insolvent (wrongful trading/fraudulent trading)
• not keeping proper accounting records
• failing to prepare and file accounts
• being guilty of three or more defaults in complying with companies' legislation regarding the filing of documents with Companies House during the preceding five years
• failing to send tax returns and pay tax
• taking actions that are deemed to be unfit in the management of a company.

Wrongful and fraudulent trading

Wrongful trading

If a company goes into insolvent liquidation and before that liquidation took place a director knew, or ought to have known, that there was no reasonable prospect that the company could avoid the liquidation, then the court can declare that the director make a personal contribution to the company's assets. However, the director will not be made personally liable in circumstances where he/she can show that he/she took every step prior to the liquidation to minimise the potential loss to the company's creditors.

Fraudulent trading

The court may also require a director to make a contribution to the company's assets if, in the course of the winding up of a company, a director was knowingly a party to the carrying on of the company's business with the intent to defraud the creditors.

The courts handle disqualification proceedings and if the courts find against the director, he/she could be disqualified for between two and 15 years.

While disqualified, a director cannot:

• be a director of any company
• act like a director, even if there is no formal appointment
• influence the running of a company through the directors
• be involved in the formation of a new company.

Ignoring a disqualification order is a criminal offence and a director could be fined and sent to prison for up to two years.

Conflict and disclosure of interests

The fiduciary duty of directors is to act in the best interests of shareholders. i.e. the directors may not put themselves in a position where their own personal interests conflict with the duties that they owe to the company as director.

A conflict of interest is a breach of this duty. The breach is in relation to the existence of the conflict and not in relation to the outcome of a situation where a breach exists.

Expandable text - Areas of conflict of interest

• Directors contracting with their own company: in general, directors cannot contract with their own company. However, the articles may specifically allow the director to have an interest as long as he discloses this interest to the board of directors.
• Substantial property transactions: the Companies Act in the UK (for example) requires any substantial asset sale above 10% of net worth to be approved by shareholders through ordinary resolution.
• Contracts with listed companies: the Listing Rules of the London Stock Exchange (for example) stipulate that any substantial contract between the company and an interested party must be agreed by ordinary resolution before the transaction takes place.
• Loans to directors: generally, loans to directors are prohibited.

Disclosure

The Companies Act 1985 (CA 1985) s232 states that companies are required, in the form of notes in the annual accounts, to disclose any information concerning transactions involving the directors. This includes any transaction or arrangement that is a material interest.

Insider dealing/trading

Insider trading is the illegal purchase or sale of shares by someone (usually a director) who possesses inside information about a company's performance and prospects which, if publicly available, might affect the share price.

• Inside information is information which is not available to the market or general public and is supposed to remain confidential.
• These types of transactions in the company's own shares are considered to be fraudulent.
• The 'director insider', simply by accepting employment, has made a contract with the shareholders to put the shareholders' interests before their own, in matters related to the company.
• When the insider buys or sells based upon company-owned information, he is violating his contract with, and fiduciary duty to, the shareholders.

Test your understanding 2

Are these scenarios examples of insider trading ?

Scenario 1

The chairman of Company ZZ knows (prior to any public announcement) that Company ZZ is to be taken over, and then buys shares in Company ZZ knowing that the share price will probably go up.

Scenario 2

While in a bar, an individual hears the CEO of Company ZZ at the next table telling the sales director that the company is to be taken over. That individual then buys the shares.

9 Directors – performance evaluation

Guidance on performance evaluation

At least once a year, the performance of the board as a whole, its committees and its members should be evaluated.

• Companies should tailor the evaluation to suit their own needs and circumstances.
• Companies should disclose in their annual reports whether such performance evaluation is taking place.
• The chairman is responsible for selection of an effective process and for acting on its outcome.
• It is suggested that the use of an external third party to conduct the evaluation will bring objectivity to the process.
• The evaluation should consist of a number of pertinent questions and answers, designed to assess performance and identify how certain elements of performance could/should be improved.
• The evaluation process will be used constructively as a mechanism to:
  • improve board effectiveness
  • maximise strengths
  • tackle weaknesses.
• The results of board evaluation should be shared with the board as a whole.
• The results of individual assessments should remain confidential between the chairman and the executive/NED concerned.

Criteria for evaluation

(1) Directors

• Intent
• The extent to which the chairman and CEO create the right forum in which expertise and wisdom can be utilised.
• Selection, nomination and departure
• How these elements take place, the quality of the process and the result in terms of directors' views on these issues.
• Composition
• Stature, integrity, courage, enthusiasm, experience and expertise of those involved.

(2) The role

• Agreeing on a board mission.
• Defining the portfolio.
• Setting priorities due to limited time.
• Board management balance of power.
• Legal requirements and its impact on board operations.
• The business environment and its impact on board operations.
• Company status and its impact on board operations.

(3) The working style

• Size, structure and committee quality.
• Meeting schedule.
• Information availability and use.
• Climate: frank, open constructive, courteous, interested, directing, helpful.

• Independence in terms of their free-standing posture.
• Preparedness in self-briefing.
• Participation in meetings.
• Committee membership.
• Positive impact on organisational activity.

Performance evaluation of the board

Some of the questions that should be considered in a performance evaluation of the board include, inter alia:

• How well has the board performed against any performance objectives that have been set?
• What has been the board's contribution to the testing and development of strategy?
• What has been the board's contribution to ensuring robust and effective risk management?
• Is the composition of the board and its committees appropriate, with the right mix of knowledge and skills to maximise performance in the light of future strategy?
• Are relationships inside and outside the board working effectively?
• How has the board responded to any problems or crises that have emerged and could or should these have been foreseen?
• Are the matters specifically reserved for the board the right ones?
• How well does the board communicate with the management team, company employees and others?
• How effectively does it use mechanisms such as the AGM and the annual report?
• Is the board as a whole up to date with latest developments in the regulatory environment and the market?
• How effective are the board's committees? (Specific questions on the performance of each committee should be included such as, e.g. their role, their composition and their interaction with the board.)

The processes that help underpin the board's effectiveness should also be evaluated:

• Is appropriate, timely information of the right length and quality provided to the board and is management responsive to requests for clarification or amplification?
• Does the board provide helpful feedback to management on its requirements?
• Are sufficient board and committee meetings of appropriate length held to enable proper consideration of issues?
• Is time used effectively?
• Are board procedures conducive to effective performance and flexible enough to deal with all eventualities?

Performance evaluation: chairman and NEDs

Some specific issues relating to the chairman (which should be included as part of an evaluation of the board's performance) include:

• Is the chairman demonstrating effective leadership of the board?
• Are relationships and communications with shareholders well managed?
• Are relationships and communications within the board constructive?
• Are the processes for setting the agenda working?
• Do they enable board members to raise issues and concerns?
• Is the company secretary being used appropriately and to maximum value?

The chairman and other NEDs should consider the following issues and the individuals concerned should also be asked to assess themselves by answering the following questions:

• How well prepared and informed are they for board meetings and is their meeting attendance satisfactory?
• Do they demonstrate a willingness to devote time and effort to understanding the company and its business and a readiness to participate in events outside the boardroom, such as site visits?
• What has been the quality and value of their contributions at board meetings?
• What has been their contribution to development of strategy and to risk management?
• How successfully have they brought their knowledge and experience to bear in the consideration of strategy?
• How effectively have they probed to test information and assumptions?
• Where necessary, how resolute are they in maintaining their own views and resisting pressure from others?
• How effectively and proactively have they followed up their areas of concern?
• How effective and successful are their relationships with fellow board members, the company secretary and senior management?
• Does their performance and behaviour engender mutual trust and respect within the board?
• How actively and successfully do they refresh their knowledge and skills and are they up to date with:
  • the latest developments in areas such as corporate governance framework and financial reporting?
  • the industry and market conditions?
• How well do they communicate with fellow board members, senior management and others, e.g. shareholders?
• Are they able to present their views convincingly yet diplomatically and do they listen and take on board the views of others?

10 Board committees

Importance of committees

Board sub-committees are a generally accepted part of board operations.

Positives that come out of the creation and use of such structures are:

• Reduces board workload and enables them to improve focus on other issues.
• Creates structures that can use inherent expertise to improve decisions in key areas.
• Communicates to shareholders that directors take these issues seriously.
• Increase in shareholder confidence.
• Communicates to stakeholders the importance of remuneration and risk.
• Satisfy requirements of the UK Corporate Governance Code (2010) (or other governance requirements).

11 Nominations committee

The need for nominations committee is identified in many codes of best practice.

As an example, the UK Corporate Governance Code (2010) requires that there should be a formal, rigorous and transparent procedure for the appointments of new directors to the board:

• Creation of a nominations committee.
• This should have a majority of NEDs, the chairman should chair except when considering his successor.
• Evaluation of candidate's skills, knowledge and expertise is vital.
• Chairman's other commitments should be noted in the annual report.
• NED terms and conditions available for inspection, other commitments stated.
• Executives should not be members of any other FTSE 100 company board.
• A separate section of the annual report should describe the work of the committee.

Responsibilities of nominations committee

The main responsibilities and duties of the nominations committee are to:

• Review regularly the structure, size and composition of the board and make recommendations to the board.
• Consider the balance between executives and NEDs on the board of directors.
• Ensure appropriate management of diversity to board composition.
• Provide an appropriate balance of power to reduce domination in executive selection by the CEO/chairman.
• Regularly evaluate the balance of skills, knowledge and experience of the board.
• Give full consideration to succession planning for directors.
• Prepare a description of the role and capabilities required for any particular board appointment including that of the chairman.
• Identify and nominate for the approval by the board candidates to fill board vacancies as and when they arise.
• Make recommendations to the board concerning the standing for reappointment of directors.
• Be seen to operate independently for the benefit of shareholders.

CEO/chairman succession

The search for a potential replacement CEO begins immediately after a new CEO is appointed:

• for the nomination committee to have access to senior managers to gauge performance
• to have some idea of a successor in case the new CEO dies or leaves
• to monitor senior managers and cultivate possible successors over time
• for a search firm ('head-hunters') to be retained for this and other directorship identification
• to think very carefully as to whether the company wants a visionary at the helm or someone who can execute strategy effectively.

12 Chapter summary

Test your understanding answers

Test your understanding 1

(a) Governance structure

(b) Board Role

Test your understanding 2

Scenario 1: Yes

Scenario 2: No

The individual that buys the shares is not guilty of insider trading unless there was some closer connection between him/her, Company ZZ or Company ZZ's directors.

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